The Time-Variation of Expected Returns and Volatility in Foreign Exchange Markets

This paper documents and analyzes the time-variation in conditional means and variances of monthly and quartely excess dollar returns on Euroyen, -pound and -mark investments. A vector autoregressive framework with weekly sampled data on exchange rate changes and forward premiums of the three currencies is used. Implications for cross-rates are derived as well. The most recent weekly change in the spot exchange rate is shown to have more predictive power for future exchange rate changes than other components of past monthly or quarterly exchange rate changes. An increase of the forward premium on the yen, mark or pound signals lower future forward market returns on all three currencies. Moreover, past second moments of forward premiums predict the volatility of exchange rates. Ex ante forward market returns are very variable and persistent. Using a nonlinear Wald test, the hypothesis that expected forward market returns pair-wise move perfectly together could never be rejected. However, the implied correlation between the yen expected return and expected returns on the European currencies is substantially weakeer than between the European currencies’ expected returns themselves.