RISK AND THE FOREIGN EXCHANGE MARKET

During the past decade, many models of exchange rate determination were developed, including the popular monetary approach. This approach takes the ratio of two money demand functions and uses purchasing power parity to derive the exchange rate between two countries. This study extends the monetary model by explicitly including a risk variable. Risk is introduced using a capital asset pricing model framework and is defined as the uncertainty of inflationary expectations. Higher variability of expected inflation should lead to a perception of higher risk. Higher variability of inflationary expectations at home relative to the foreign country would have an unfavorable effect on the domestic currency. Logically risk should be in the monetary model and its inclusion should improve its explanatory power.; It is shown that the monetary model is unstable. Obviously important variables have been omitted. Therefore, risk is included but empirical testing is not convincing as money demand functions do not behave well with or without inclusion of risk.; Applying appropriate estimation techniques to quarterly money demand functions for the U.S. gives significant coefficients for risk with the correct sign. The problem with these functions (both monthly and quarterly) is serial correlation of the errors and existence of multiple minima in the standard error of regression function. The results depend critically on the size of the first order serial correlation coefficient used in the correction process.; The negative risk coefficient, in the quarterly money demand functions for the U.S., contrasts with Klein's positive estimate. The reasons may be the difference in the estimation period, data frequency, the length of the expectations adjustment process or the inadequacy of the moving variance of past inflation rates to proxy future price uncertainty.; Several proxies for risk using past rates of inflation are included in the exchange rate equations. Unfortunately, inclusion of risk does not improve the specification of the already unstable monetary model. However, some formulations of risk are significant with the correct sign. The results are improved when the equation tests the hypothesis that the changes in exchange rates follow a random walk. Risk adds to the explanatory power of these equations suggesting it should be included in models of exchange rate determination.