Currency risk premia: Perceptions of downside risk and deviations from benchmark values

Abstract

This paper examines the empirical performance of an alternative model of the currency risk premium. This model relates risk not to the variance of returns but rather to potential crash risk based on the deviation, or “gap,” between the exchange rate and perceptions of its benchmark value. The model is tested using a novel data set of traders' exchange rate forecasts, from 1986:08 to 2013:09. The forecast data eliminate the need for a joint hypothesis about expectations formation through direct measurement of the market's ex ante premium. To measure the benchmark value, rather than use purchasing power parity, we relate it to recent levels through a moving average. Strong support is found for the prediction that the premium comoves positively with the “gap” measure of risk, according to cointegrated vector autoregression analyses for all four markets examined. This result is robust for moving averages from six to 24 months and when controlling for exchange rate volatility. The findings suggest how investors assess downside risk ex ante, at least in part, and may rationalize the application of certain technical analysis.