1

Macroeconomic sources of FOREX risk

P.N. Smith, S. Sorensen and M.R. Wickens
University of York
Abstract
This paper considers the problem of measuring macroeconomic
sources of financial risk.
1. It aims to provide a general theory 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 empirical
literature of asset pricing have a fundamental flaw: they admit unlimited arbitrage opportunities. High profile suites of computer programs
just produced and sold world-wide suer 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 Englands Monetary Policy Committee), and to
testing FOREX market eciency. The forward premium puzzle lies
at the heart of the diculty of doing this. The theoretical results of
this paper are used to re-examine the distribution of exchange rate
movements and to try to resolve this puzzle.
Stochastic discount factor theory is used to derive expressions for
the risk premia for domestic and foreign investors. It is shown that
these are likely to be dierent. A combined theory of market risk
when both types of investor are trading is then obtained. The cases
of complete and incomplete markets are considered. It is shown how
macroeconomic sources of risk can be introduced by modelling the

stochastic discount factor using observable macroeconomic variables.

Three SDF models are compared: a benchmark model which provides a reformulation of traditional tests of FOREX eciency; intertemporal consumption-based CAPM; and the monetary model of the
exchange rate, a familiar macroeconomic model of FOREX which can
be interpreted as arising from traditional hedging concerns.
The joint distribution of the excess return to foreign exchange and
the macro factors is specified in a way that satisfies the no-arbitrage
assumption. It is assumed that the joint distribution has multivariate
GARCH and it is shown that to eliminate arbitrage opportunities it
is necessary for the conditional distribution of the excess return to
exhibit GARCH-in-mean. The omission of the conditional covariance
between the excess return and the sources of risk is the reason why
nearly all financial statistical packages are not suitable for use in financial econometrics. The presence of this term implies that the analysis
must be conducted in a multi-variate and not a uni-variate framework.
The theory admits the possibility that domestic and foreign investors may have dierent attitudes to risk. This is incorporated into
the model by introducing a switching formulation of the conditional
covariance structure. Extreme changes in exchange rates suggest that
the usual assumption of log-normality may fail to capture the excess
kurtosis of excess returns. The model is therefore also estimated assuming a log t-distribution. It is notoriously dicult to achieve convergence in multi-variate GARCH models, and GARCH-in-mean eects
increase the diculty. This is a major limitation in the practicality
of the whole approach. It is shown that assuming constant correlation greatly simplifies the estimation without sacrificing any essential
elements.
Tests are conducted to enable a comparison of dierent SDF models, dierent market structures, dierent attitudes to risk, and dierences between the SDF model and the Fama approach. The empirical
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.
Keywords: FOREX, market eciency, risk premium, stochastic
discount factors, GARCH.
JEL classification: G1, F1
Notes: This paper is a substantially revised version of Can stochastic discount factors explain the FOREX risk premium, mimeo.
Financial support for this research was provided by ESRC grants
L138251023 and R000237862.

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Figure 1. Plot of R(t+1) against f(t)-s(t)

150
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Table 1
Unconditional correlation with the excess return ( 1 j )
f s
-0.209

i us

c us

cuk

p us

puk

mus

muk

y us

y uk

-0.076

-0.079

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0.002

0.055

0.095

-0.002

-0.179

-0.092

Table 2a
Estimates of the benchmark model of the FOREX excess return
The excess return equation in the multivariate GARCH in mean model
Normal distribution
Dependent
Variable

US

UK

Constant

Vt ( Rt +1 )

-0.0004

0.0004

Ct ( Rt +1 , ft +1 st +1 )

0.063
(0.66)
-0.073
(0.55)

0.047
(0.49)
-0.078
(0.58)

1251.6
(3.30)
0.617
(4.96)
0.266
(2.73)

1246.3
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0.622
(5.00)
0.261
(2.71)

Ct ( Rt +1 , itus+1 )
Rt
f t st
itus
Conditional variance
Constant

t2 ( Rt +1 )
t2
t2

Notes: 1. Dependent variable is

2. Ct ( xt +1 , yt +1 ) =

US & UK General
Non-switching
model
1.636
(0.31)
-0.004
(0.64)
0.057
-0.084
(0.62)
(0.78)
-0.078
0.048
(0.58)
(0.38)
0.352
(5.68)
-1.683
(2.51)
-1.899
(1.03)
1257.1
(2.89)
0.620
(5.10)
0.265
(2.56)

914.9
(5.25)
0.662
(5.02)
0.164
(2.34)

US & UK General
switching model

0.050
(0.56)
-0.065
(0.49)

1177.7
(3.57)
0.659
(6.02)
0.290
(3.57)
-0.123
(1.31)

Rt +1

hxx (t + 1).hyy (t + 1) , where hxx (t + 1) is the conditional variance of xt +1

3. Numbers in parentheses are t-statistics

1.684
(0.31)
-0.005
(0.63)
-0.087
(0.79)
0.048
(0.38)
0.345
(5.33)
-1.790
(2.36)
-1.914
(1.01)
912.8
(5.38)
0.679
(4.85)
0.173
(2.32)
-0.040
(0.37)

Table 2b
Estimates of the benchmark model of the FOREX excess return
The excess return equation in the multivariate GARCH in mean model
t-distribution
Dependent
Variable

US

UK

Constant

Vt ( Rt +1 )

-0.0004

0.0004

Ct ( Rt +1 , ft +1 st +1 )

0.088
(0.97)
-0.103
(0.82)

0.069
(0.76)
-0.106
(0.85)

1402.4
(2.01)
0.638
(4.49)
0.263
(2.24)

1383.0
(2.06)
0.648
(4.60)
0.254
(2.21)

Ct ( Rt +1 , itus+1 )
Rt
f t st
itus
Conditional variance
Constant

t2 ( Rt +1 )
t2
t2

Notes: 1. Dependent variable is

2. Ct ( xt +1 , yt +1 ) =

US & UK General
Non-switching
model
4.551
(0.68)
-0.009
(1.03)
0.081
-0.115
(0.88)
(1.08)
-0.109
0.074
(0.86)
(0.62)
0.334
(5.62)
-2.271
(3.37)
-1.843
(1.04)
1395.4
(2.02)
0.643
(4.55)
0.259
(2.23)

867.4
(5.49)
0.624
(3.93)
0.149
(2.00)

US & UK General
switching model

0.063
(0.69)
-0.079
(0.63)

1271.0
(2.66)
0.652
(4.17)
0.291
(2.61)
-0.100
(0.97)

Rt +1

hxx (t + 1).hyy (t + 1) , where hxx (t + 1) is the conditional variance of xt +1

3. Numbers in parentheses are t-statistics

4. Degrees of freedom = 9

4.751
(0.68)
-0.010
(1.01)
-0.117
(1.08)
0.074
(0.61)
0.327
(5.27)
-2.357
(3.17)
-1.863
(1.03)
869.6
(5.51)
0.645
(3.95)
0.162
(1.99)
-0.042
(0.42)

Table 3a
Estimates of the C-CAPM for the FOREX excess return
The excess return equation in the multivariate GARCH in mean model
Normal distribution
Dependent
Variable

US

UK

Constant

Vt ( Rt +1 )

-0.0004

Ct ( Rt +1 , ctus+1 )

0.0004

0.024
(2.09)

Ct ( Rt +1 , ctuk+1 )

-0.016
(1.92)

Ct ( Rt +1 , ptus+1 )

-0.104
(1.68)

Ct ( Rt +1 , ptuk+1 )

0.039
(2.02)

Rt
f t st
Conditional variance
Constant

t2 ( Rt +1 )
t2

1290.3
(2.96)
0.627
(5.45)
0.269
(2.92)

t2
Notes: 1. Dependent variable is
2. Ct ( xt +1 , yt +1 ) =

1252.2
(3.19)
0.607
(5.28)
0.277
(3.08)

US & UK General
Non-switching
model
-0.282
(0.031)
-0.003
(0.36)
0.027
0.021
(2.20)
(1.39)
-0.012
-0.013
(1.23)
(1.45)
-0.030
-0.061
(0.22)
(0.35)
-0.013
0.005
(0.21)
(0.066)
0.351
(5.14)
-1.722
(2.70)
1283.1
(2.87)
0.624
(5.56)
0.273
(3.05)

921.3
(5.08)
0.676
(5.76)
0.175
(2.87)

US & UK General
switching model

0.028
(1.91)
-0.037
(0.56)
0.020
(0.13)
-0.162
(1.57)

1.379
(0.15)
-0.005
(0.50)
0.015
(0.87)
-0.013
(1.49)
-0.011
(0.06)
-0.010
(0.15)
0.330
(5.13)
-2.057
(2.31)

1167.5
(3.67)
0.674
(6.73)
0.298
(4.16)
-0.162
(1.57)

953.1
(4.49)
0.737
(6.11)
0.211
(2.72)
-0.136
(1.40)

Rt +1

hxx (t + 1).hyy (t + 1) , where hxx (t + 1) is the conditional variance of xt +1

3. Numbers in parentheses are t-statistics

Table 3b
Estimates of the C-CAPM for the FOREX excess return
The excess return equation in the multivariate GARCH in mean model
t-distribution
Dependent
Variable
Constant

Vt ( Rt +1 )

US

UK

-0.0004

0.0004

Ct ( Rt +1 , ctus+1 )

0.019
(1.85)

Ct ( Rt +1 , ctuk+1 )

-0.017
(2.17)

Ct ( Rt +1 , ptus+1 )

-0.073
(1.34)

Ct ( Rt +1 , ptuk+1 )

0.043
(2.33)

Rt +1
f t st
Conditional variance
Constant

t2 ( Rt +1 )
t2

1424.4
(1.94)
0.642
(4.56)
0.262
(2.26)

t2
Notes: 1. Dependent variable is
2. Ct ( xt +1 , yt +1 ) =

1366.0
(2.03)
0.632
(4.63)
0.268
(2.36)

US & UK General
Non-switching model
0.624
(0.07)
-0.015
(1.48)
0.016
0.013
(1.50)
(1.06)
-0.017
-0.020
(1.97)
(2.19)
-0.087
0.034
(1.20)
(0.28)
0.047
0.061
(1.83)
(1.98)
0.332
(5.00)
-2.432
(3.95)
1426.3
(1.76)
0.636
(4.79)
0.273
(2.37)

850.7
(5.56)
0.649
(3.98)
0.145
(2.03)

US & UK General
switching model
0.905
(0.12)
-0.014
(1.25)
0.019
0.007
(1.22)
(0.45)
-0.017
-0.022
(2.35)
(2.69)
-0.086
0.001
(1.00)
(0.01)
0.044
0.054
(1.50)
(1.63)
0.309
(5.10)
-2.664
(2.68)
1298.0
(2.58)
0.666
(6.83)
0.300
(3.74)
-0.124
(1.15)

Rt +1

hxx (t + 1).hyy (t + 1) , where hxx (t + 1) is the conditional variance of xt +1

3. Numbers in parentheses are t-statistics

4. Degrees of freedom = 9

969.3
(3.28)
0.752
(6.78)
0.218
(2.47)
-0.168
(1.74)

Table 4a
Estimates of the monetary model of the FOREX excess return
The excess return equation in the multivariate GARCH in mean model
Normal distribution
Dependent
Variable
Constant

US

UK

Vt ( Rt +1 )

-.0004

0.0004

Ct ( Rt +1 , mtus+1 )

0.131
(1.25)
-0.089
(2.27)

Ct (Rt+1, mtuk+1)
Ct ( Rt +1 , ytus+1 )

-0.041
(1.16)

Ct ( Rt +1 , ytuk+1 )

0.042
(2.55)

Rt
f t st
Conditional variance
Constant
1185.0
(3.97)
2
0.621
t ( Rt +1 )
(4.75)
0.244
t2
(2.78)

1181.2
(3.46)
0.628
(5.29)
0.250
(2.68)

US & UK
General
Non-switching model
21.898
(2.04)
0.011
(1.02)
0.121
-0.343
(1.48)
(1.58)
-0.034
-0.029
(0.84)
(0.73)
-0.109
-0.070
(2.84)
(1.77)
0.054
0.034
(3.41)
(2.11)
0.321
(5.13)
-1.333
(2.17)
1099.6
(3.76)
0.634
(5.53)
0.227
(2.54)

t2
Notes: 1. Dependent variable is
2. Ct ( xt +1 , yt +1 ) =

946.3
(3.93)
0.698
(6.43)
0.179
(2.58)

US & UK
General
switching model
23.150
(1.86)
0.009
(0.66)
0.141
-0.331
(1.82)
(1.25)
-0.080
-0.044
(2.15)
(1.03)
-0.094
(2.71)

-0.071
(1.61)

0.064
(4.69)

0.039
(2.20)
0.306
(4.68)
-1.635
(1.97)

952.6
(6.31)
0.621
(8.08)
0.369
(4.81)
-0.332
(3.49 )

990.3
(4.10)
0.713
(6.99)
0.236
(3.07)
-0.141
(1.66)

Rt +1

hxx (t + 1).hyy (t + 1) , where hxx (t + 1) is the conditional variance of xt +1

3. Numbers in parentheses are t-statistics

Table 4b
Estimates of the monetary model of the FOREX excess return
The excess return equation in the multivariate GARCH in mean model
t-distribution
Dependent
Variable

US

UK

Constant

Vt ( Rt +1 )

-0.0004

Ct ( Rt +1 , mtus+1 )

0.153
(1.68)

Ct ( Rt +1 , mtuk+1 )
Ct ( Rt +1 , ytus+1 )

0.0004

-0.080
(2.23)
-0.049
(1.59)

Ct ( Rt +1 , ytuk+1 )

0.038
(2.49)

Rt +1
f t st
Conditional variance
Constant

t2 ( Rt +1 )
t2

1216.8
(2.83)
0.644
(4.20)
0.231
(2.15)

t2
Notes: 1. Dependent variable is
2. Ct ( xt +1 , yt +1 ) =

1286.0
(2.29)
0.642
(4.54)
0.251
(2.22)

US & UK General
Non-switching
model
13.139
(1.29)
-0.001
(0.058)
0.140
-0.093
(1.85)
(0.47)
-0.020
-0.013
(0.50)
(0.34)
-0.115
-0.080
(3.20)
(2.20)
0.048
0.027
(3.29)
(1.75)
0.306
(5.04)
-1.928
(2.80)
1153.5
(3.01)
0.647
(5.49)
0.230
(2.41)

866.0
(4.69)
0.687
(4.87)
0.147
(2.08)

US & UK General
switching model

0.168
(1.93)
-0.053
(1.43)
-0.110
(3.07)
0.056
(3.94)

13.803
(1.32)
-0.001
(0.06)
-0.102
(0.50)
-0.019
(0.44)
-0.083
(2.08)
0.029
(1.76)
0.292
(4.64)
-2.110
(2.49)

1013.6
(5.30)
0.631
(5.42)
0.359
(3.08)
-0.321
(2.83)

911.8
(4.12)
0.734
(6.29)
0.191
(2.49)
-0.110
(1.28)

Rt +1

hxx (t + 1).hyy (t + 1) , where hxx (t + 1) is the conditional variance of xt +1

3. Numbers in parentheses are t-statistics

4. Degrees of freedom = 10

Table 5a
Estimates of the combined model of the FOREX excess return
The excess return equation in the multivariate GARCH in mean model
Normal distribution
Dependent
Variable

US

UK

constant
Vt ( Rt +1 )

-0.0004

0.0004

Ct ( Rt +1 , f t +1 st +1 )

0.133
(0.94)
-0.114
(0.76)
0.033
(2.43)

-0.121
(0.92)
-0.039
(0.34)

Ct ( Rt +1 , itus+1 )
Ct ( Rt +1 , ctus+1 )
Ct ( Rt +1 , ctuk+1 )

-0.022
(2.63)

Ct ( Rt +1 , ptus+1 )

0.179
(0.91)

Ct ( Rt +1 , ptuk+1 )

-0.037
(0.84)

Ct ( Rt +1 , mtus+1 )

-0.087
(0.53)

Ct ( Rt +1 , mtuk+1 )

-0.027
(0.52)
-0.093
(1.89)

Ct ( Rt +1 , ytus+1 )

0.063
(3.23)

Ct ( Rt +1 , ytuk+1 )

Rt
f t st
Conditional variance
Constant

1236.3
(3.34)
0.600
(4.45)
0.274
(2.86)

t2 ( Rt +1 )
t2
t2
Notes: 1. Dependent variable is
2. Ct ( xt +1 , yt +1 ) =

1163.0
(3.22)
0.612
(5.09)
0.270
(2.79)

US & UK General
Non-switching
model
8.806
(0.48)
-0.006
(0.31)
-0.182
-0.300
(1.15)
(1.47)
-0.011
0.200
(0.08)
(1.51)
0.023
0.016
(1.64)
(0.97)
-0.030
-0.028
(4.44)
(2.90)
-0.043
-0.312
(0.22)
(1.51)
0.222
0.129
(1.47)
(0.61)
-0.124
-0.022
(0.70)
(0.072)
-0.018
0.010
(0.35)
(0.186)
-0.208
-0.105
(3.22)
(1.42)
0.070
0.059
(4.33)
(3.26)
0.300
(4.80)
-1.775
(2.61)
1166.2
(2.82)
0.538
(4.13)
0.324
(2.70)

867.8
(4.89)
0.634
(4.46)
0.190
(2.30)

US & UK General
switching model

-0.143
(0.91)
-0.058
(0.45)
0.019
(1.35)
-0.025
(2.98)
0.031
(0.16)
-0.018
(0.12)
0.090
(0.51)
-0.029
(0.58)
-0.131
(2.18)
0.095
(6.34)

10.159
(0.59)
-0.005
(0.25)
-0.277
(1.41)
0.194
(1.47)
0.017
(1.07)
-0.028
(3.24)
-0.310
(1.57)
0.131
(0.64)
-0.057
(0.20)
0.009
(0.16)
-0.107
(1.52)
0.059
(3.34)
0.310
(4.85)
-1.657
(2.55)

904.1
(5.70)
0.658
(9.38)
0.332
(4.73)
-0.293
(2.62)

726.1
(3.02)
0.628
(4.60)
0.173
(2.10)
0.078
(0.57)

Rt +1

hxx (t + 1).hyy (t + 1) , where hxx (t + 1) is the conditional variance of xt +1

3. Numbers in parentheses are t-statistics

Table 5b
Estimates of the combined model of the FOREX excess return
The excess return equation in the multivariate GARCH in mean model
t-distribution
Dependent
Variable

US

UK

Vt ( Rt +1 )

-0.0004

0.0004

Ct ( Rt +1 , f t +1 st +1 )

0.152
(1.18)
-0.129
(0.99)
0.028
(2.43)

-0.077
(0.58)
-0.088
(0.77)

Constant

Ct ( Rt +1 , itus+1 )
Ct ( Rt +1 , ctus+1 )
Ct ( Rt +1 , ctuk+1 )

-0.025
(2.98)

Ct ( Rt +1 , ptus+1 )

0.272
(1.70)

Ct ( Rt +1 , ptuk+1 )

-0.009
(0.20)

Ct ( Rt +1 , mtus+1 )

-0.031
(0.24)

Ct ( Rt +1 , mtuk+1 )

-0.036
(0.71)
-0.136
(3.00)

Ct ( Rt +1 , ytus+1 )

0.056
(3.36)

Ct ( Rt +1 , ytuk+1 )

Rt
f t st
Conditional variance
Constant

1184.3
(2.84)
0.629
(3.99)
0.241
(2.18)

t2 ( Rt +1 )
t2
t2
Notes: 1. Dependent variable is
2. Ct ( xt +1 , yt +1 ) =

1166.2
(2.48)
0.626
(4.58)
0.261
(2.34)

US & UK General
Non-switching model
0.644
(0.037)
-0.019
(1.09)
-0.159
-0.382
(1.02)
(2.00)
0.009
0.234
(0.07)
(1.76)
0.023
0.016
(1.55)
(0.98)
-0.033
-0.035
(4.03)
(3.10)
0.026
-0.162
(0.14)
(0.85)
0.132
0.091
(1.26)
(0.63)
-0.051
0.135
(0.38)
(0.64)
-0.002
0.049
(0.03)
(0.89)
-0.177
-0.105
(3.47)
(2.04)
0.064
0.053
(4.10)
(2.92)
0.273
(4.63)
-2.511
(3.69)
1087.5
(2.95)
0.580
(4.56)
0.281
(2.49)

764.9
(5.92)
0.644
(4.38)
0.138
(2.01)

US & UK General
switching model
0.556
(0.04)
-0.019
(1.17)
-0.071
-0.391
(0.46)
(2.11)
-0.049
0.237
(0.38)
(1.82)
0.023
0.016
(1.62)
(1.01)
-0.027
-0.036
(2.98)
(3.29)
0.074
-0.165
(0.41)
(0.87)
0.040
0.096
(0.38)
(0.69)
0.038
0.138
(0.30)
(0.72)
-0.027
0.049
(0.53)
(0.91)
-0.150
-0.107
(3.07)
(2.10)
0.071
0.054
(4.57)
(2.91)
0.277
(4.23)
-2.483
(3.53)
983.8
(4.37)
0.640
(8.50)
0.350
(4.64)
-0.259
(2.23)

Rt +1

hxx (t + 1).hyy (t + 1) , where hxx (t + 1) is the conditional variance of xt +1

3. Numbers in parentheses are t-statistics

4. Degrees of freedom = 10

733.9
(3.78)
0.643
(4.40)
0.131
(1.66)
0.017
(0.18)