FINA 470 Lecture Notes - Lecture 9: Opportunity Cost, Risk Premium, A Black Box
5 Mar 2016
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Has number of implications: currency by currency mean tests: Can compute a series of ex post forecast errors and test whether its average reject hypothesis that errors have zero expectation. If conditional expected error is zero then expectation must be zero unconditionally. So can plot and test whether mean deviates from zero: cross currency patterns in currency by currency means: for every currency j we can compute mean realized change in sj and forward premium fpj Standard t-test shows clear link between forward premium and exchange rate changes on average. Expected excess return is never significantly non-zero. Results in below unity, which means for every 1% forward premium on average means less than 1% appreciation. This means strong currencies are bas investments while weak currencies are good investments. Carry trade then, of borrowing low and investing in high value currency pays on average. Forward premium predicts a smaller rise and a forward discount a small fall on average.
