The Intertemporal Relation between Expected Return and Risk on Currency

Abstract

Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in ABSTRACTThe literature has so far focused on the risk-return tradeoff in equity markets and ignored alternative risky assets. This paper examines the presence and significance of an intertemporal relation between expected return and risk in the foreign exchange market. The paper provides new evidence on the intertemporal capital asset pricing model by using high-frequency intraday data on currency and by presenting significant time-variation in the risk aversion parameter. Five-minute returns on the spot exchange rates of the U.S. dollar vis-à-vis six major currencies (the Euro, Japanese Yen, British Pound Sterling, Swiss Franc, Australian Dollar, and Canadian Dollar) are used to test the existence and significance of a daily risk-return tradeoff in the FX market based on the GARCH, realized, and range volatility estimators. The results indicate a positive, but statistically weak relation between risk and return on currency.

Risk and Return Dynamics

“…In contrast, Goyal and Santa-Clara (2003) find an insignificant relation when using an unconditional measure of market variance. Bali (2008) and Bali and Engle (2008) also show that the use of conditional covariances is crucial in identifying a positive risk-return tradeoff. Moreover, given the empirical evidence on time-varying betas (see, for instance, Bollerslev, Engle, and Wooldridge (1988) and Jagannathan and Wang (1996)), I allow for time variation in these conditional covariances.…”

“…The SUR model accounts for heteroskedasticity, autocorrelation, and contemporaneous correlation across residuals to estimate the system more efficiently by FGLS. 22 Details are in Bali (2008).…”