The two portfolio balance models imply different risk factors. Both models relate the risk premium on foreign currency to the country's bilateral international debt position (IDP). With EUT, the risk premium also depends on the conditional volatility of returns. With prospect theory, the premium depends positively on the gap between the exchange rate and market participants' assessments of benchmark value. The "gap effect" is intuitive: the more over- or under-valued a currency becomes, the riskier it is for market participants who speculate on a further over- or undervaluation. The two models' predictions for sign reversals also differ. With the PT model, sign reversals depend on risk assessments of the bulls relative to the bears.
Our empirical analysis estimates models using ex ante currency returns, which we measure with monthly survey data on exchange rate expectations from Money Market Services International and interest rate data from DRI Basic Economics. Other risk premium studies estimate models using ex post returns, drawing inference under the rational expectations hypothesis (REH). Inference involves joint tests of the models' predictions concerning expected excess returns and REH's prediction that ex ante and ex post outcomes differ by white noise errors. There is considerable evidence against REH's white-noise-error prediction, suggesting that the negative results of earlier studies may arise in part from a failure of REH. The use of ex ante returns enables us to test directly the competing implications of the portfolio balance approach under EUT and prospect theory without the joint hypothesis problem.
The empirical analysis relies on the cointegrated vector auto-regression (VAR) framework, which is well suited for testing competing models and dealing with unit roots. We find little support for the expected utility theory model. In contrast, the prospect theory model's predictions are largely borne out in the data, including those about sign reversals. We find the strongest support for a hybrid model that incorporates risk factors of both portfolio balance specifications.