The intertemporal relation between expected return and risk on currency

Abstract

The literature has so far focusedon the risk-return trade-off in equity markets and ignored alternative risky assets.This paper examines the presence and significance ofan intertemporal relation between expected return and risk in the foreign exchange market. The paper provides new evidence on the intertemporal capital asset pricing model by using high-frequency intraday data on currency and by presenting significant time variation in the risk aversion parameter. Five-minute returns on the spot exchange rates of the US dollar vis-a`-vis six major currencies (the euro, Japanese yen, British pound sterling, Swiss franc, Australian dollar, and Canadian dollar) are used to test the existence and significance of a daily risk-return trade-off in the FX market based on the GARCH, realized, and range volatility estimators. The results indicate a positive but statistically weak relation between risk and return on currency.Our empirical analysis relies on the maximum likelihood estimation of the GARCH-in-mean models as described in Appendix 1. We also usethe seemingly unrelated (SUR) regressions and panel data estimation to investigate the significance of a time-series relation between expected return and risk on currency as described in Appendix 2.