In this paper we present the first evidence on the impact of macroeconomic factors for explaining the foreign exchange risk premium in selected new EU member countries. The previous attempts to explain foreign exchange risks in post-transition economies were based on univariate models, which disregard the conditional covariance terms and allow for arbitrage possibilities.

We address the issue of foreign exchange risk and its macroeconomic determinants in several new EU members. The joint distribution of excess returns in the foreign exchange market and the observable macroeconomic factors is modeled using the stochastic discount factor (SDF) approach and a multivariate GARCH-in-mean model.

The estimation results suggest that real factors play only a small role in explaining the variability in foreign exchange returns. This finding contradicts the evidence coming from more developed economies. Furthermore, the monetary factor, which is disregarded in standard C-CAPM models, has significant explanatory power for the case of post-transition economies. This implies that monetary policy has an important effect on the behavior of exchange rates in post-transition economies and investors make use of this information in pricing contingent claims.

The results also suggest that there are important differences across post-transition countries. The impacts of different factors have different magnitudes and even different signs for different countries, which is related to underlying systemic differences across post-transition countries.

Our findings also have straightforward policy recommendations. To contribute to the further stability of the domestic currency, the central banks in the new EU members should continue stabilization policies aimed at achieving nominal convergence with the core EU members, as nominal factors play a crucial role in explaining the variability of the risk premium.