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Journal of Economics and Finance

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01-04-2015

Macroeconomic sources of foreign exchange risk premium: evidence from South Africa

Author: Bernard Jagre Walley

Published in: Journal of Economics and Finance | Issue 2/2015

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Abstract

This study investigates the macroeconomic sources of foreign exchange risk premium in South Africa using the stochastic discount factor (SDF) approach based on observable macroeconomic factors. Using the multivariate GARCH-in-mean model with no-arbitrage condition, I find support for the role of nominal and real macroeconomic factors as important determinants of foreign exchange risk premium in South Africa. However, while inflation rate and broad money growth are associated higher risk premium, consumption growth appears to be associated with lower risk premium. Finally, the time varying nature of foreign exchange risk premia in South Africa suggest that, policymakers in South Africa need to broaden their analysis of fluctuations in foreign exchange rates to include an assessment of the foreign exchange risk premia.

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Interested readers should see Smith and Wickens (2002) for a detailed discussion of stochastic discount factor model and its applications.

See Smith and Wickens (2002), Cochrane (2001) and Smith and Wickens (2002) for an excellent survey of Stochastic Discount Factor models.

Here I am using the a property of moment generating functions.

This argument is consistent with economic theory. Interested readers should consult Smith and Wickens (2002) for more details.

In particular, Dornbusch (1976) overshooting hypothesis predicts that the exchange rate will initially overshoot its long run equilibrium level in response to an exogenous monetary shock. Some recent studies have found support for the hypothesis, see for example Huiznga (1987), Clarida (1987), Clarida and Gali (1994), Eichenbaum and Evans(1995), Grilli and Roubini (1996).

The money supply here refers to the M3 money supply for South Africa

See Ding and Engle (2001), Smith et al. (2003), Smith and Wickens (2002), Bollerslev et al. (1992, 1994) for a detailed discussion.

The name BEKK is after the authorship of that paper.

See Engle and Kroner (1995) for the latest published version of BEKK model. To further reduce the parameters to be estimated, I restrict the matrices A and B in the conditional variance covariance matrix to a diagonal matrix.

Consumption growth data are not available monthly. The practice in the literature is to replace it with retail sales.

Note that we consider South Africa as the home country and U.S as the foreign country. Thus, we examine risk from the point of view of the South African investor.

The rand is the currency of South Africa.

Using the t-distribution imply that the Jensen effect in Eq. (8) has to vanish because the moment generating function for a t-distribution doesn’t exist.

See Kocenda and Poghosyan (2010).

The rest of the table are not of interest for this study. Nonetheless, I report them here in case some readers desire to see the entire results.

A similar approach was implemented by Kocenda and Poghosyan (2010)

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Title: Macroeconomic sources of foreign exchange risk premium: evidence from South Africa
Author: Bernard Jagre Walley
Publication date: 01-04-2015
Publisher: Springer US
Published in: Journal of Economics and Finance / Issue 2/2015
Print ISSN: 1055-0925
Electronic ISSN: 1938-9744
DOI: https://doi.org/10.1007/s12197-013-9268-9

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