Macroeconomic Sources of FOREX Risk

Mike WICKENS (University of York, UK)
Peter N. SMITH (University of York, UK)

This paper considers the problem of measuring macroeconomic sources of financial risk.

1. It aims to probvide a general theaory of asset pricing suitable for taking account of macroeconomic sources of risk. Stochastic discount factor theory is used to provide the theoretical framework. This is capable of embracing most of the approaches in the literature, including general equilibrium theory. Market structure needs to be added to this.

2. It is shown that many of the models used in the emprical literature of asset pricing have a fundamental flaw: they admit unlimited arnitrage opportunities. High profile suites of computer programs just produced and sold world-wide suffer the same problem, and hence should not be used.

3. Modelling the exchange rate is key to much of monetary policy (eg the Bank of New England's Monetary Policy Committee), and to testing FOREX market efficiency. The forward premium puzzle lies at the heart of the difficulty of doing this. The theoratical results of this paper are used to re-examine the distribution fo exchange rate movements and try to resolve this puzzle.

Tests are conducted to enable a comparison of different SDF models, different amrket structures, different attitudes to risk, and differences between the SDF model and the Fama approach. The emprical work is based on monthly data for the sterling-dollar exchange rate 1975-1997. Our main new finding is that the evidence is more consistent with the FOREX risk premium arising from traditional partial equilibrium models of currency risk that form the basis of hedging than with consumption-CAPM, a general equilibrium theory. In particular, US and UK output appear to be important sources of FOREX risk.