Saturday, 27 March 2010: 17:05
Uncertainty and Risk Premium Puzzle
Heeho Kim
Professor, Department of Economics, KyungpookNational University , (South) Korea
82-(0)53-950-5438, kimhh@knu.ac.kr
Abstract
This article purposes to explore an error model of risk premium in order to explain the forward premium anomaly and premium puzzle in an unstable market. A consumer is assumed to revise his expectation about market uncertainty whenever the market becomes unstable unexpectedly. This revision incurs non-trivial errors uncompensated by an initial level of premium. Premium would increases due to this error even under the assumption of a traditional expected utility function and rational expectation. The premium puzzle might be a phenomenon pertaining to the unstable foreign exchange market. Risk premium is composed of two parts. The first part is its linear relationship with expected changes in the exchange rate at an initial expectation, and the second is its nonlinear response to revision of his expectation about uncertainty. In the literature, the second one was ignored as forecasting errors under the assumption of rational expectation. Using the monthly data of Asian countries experiencing the currency crisis for the market uncertainty during January 1994~December 2008, a relationship between premium and expected changes in the exchange rate are estimated in the unstable markets and compared with that relationship in the stable markets. Evidence strongly supports our hypothesis. The relationship between premium and expected changes in the exchange rate tends to strongly increase in the unstable market. This is because the premium considers additional errors caused by consumer’s revision of expectation about market uncertainty. This study is very meaningful to re-focus on the ex-ante concept of premium as a compensation for the unexpected exchange risk.
JEL: F3,
Key words: Measurement error, risk aversion, premium puzzle, forward premium anomaly
Heeho Kim
Professor, Department of Economics, Kyungpook
82-(0)53-950-5438, kimhh@knu.ac.kr
Abstract
This article purposes to explore an error model of risk premium in order to explain the forward premium anomaly and premium puzzle in an unstable market. A consumer is assumed to revise his expectation about market uncertainty whenever the market becomes unstable unexpectedly. This revision incurs non-trivial errors uncompensated by an initial level of premium. Premium would increases due to this error even under the assumption of a traditional expected utility function and rational expectation. The premium puzzle might be a phenomenon pertaining to the unstable foreign exchange market. Risk premium is composed of two parts. The first part is its linear relationship with expected changes in the exchange rate at an initial expectation, and the second is its nonlinear response to revision of his expectation about uncertainty. In the literature, the second one was ignored as forecasting errors under the assumption of rational expectation. Using the monthly data of Asian countries experiencing the currency crisis for the market uncertainty during January 1994~December 2008, a relationship between premium and expected changes in the exchange rate are estimated in the unstable markets and compared with that relationship in the stable markets. Evidence strongly supports our hypothesis. The relationship between premium and expected changes in the exchange rate tends to strongly increase in the unstable market. This is because the premium considers additional errors caused by consumer’s revision of expectation about market uncertainty. This study is very meaningful to re-focus on the ex-ante concept of premium as a compensation for the unexpected exchange risk.
JEL: F3,
Key words: Measurement error, risk aversion, premium puzzle, forward premium anomaly