The Foreign Exchange Risk Premium Over the Long Run

This paper analyses the behavior of the foreign exchange risk premium using longhorizon regressions. A long-horizon analysis may provide new evidence about three key issues concerning the foreign exchange risk premium. The Þrst issue is the relationship between expected foreign exchange returns and expected returns on other assets. Long-horizon regressions are able to explain a large portion of the variation of foreign exchange returns using instruments that have been shown to predict domestic asset returns. I undertake a careful small-sample study to examine the size of the statistics and provide evidence of increased power. The second issue is the high variability of the foreign exchange risk premium. Using the long-horizon regression results, I show that Fama’s (1984) Þnding that the variability of the risk premium is greater than that of the expected change in the spot rate holds even for horizons extending out to four years and is, therefore, not the result of market frictions which would bind only in the short run. The third issue is the economic model that can explain foreign exchange risk premia. I show that both the length of the holding period and the inclusion of global and local risk factors are important for tests of latent variable models.