DP352 | On the Nature of Risk in the Foreign Exchange Markets: Evidence from the Dollar and the EMS Markets


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In this paper we analyze the behavior of the risk premia in exchange markets with very different exchange rate regimes: free floating (dollar markets), the low credibility EMS regime (e.g., Lira/DM and FF/DM) and the high credibility EMS regime (guilder/DM). We find that in the first and the third regime the risk premia behave in similar ways, i.e., they are negatively correlated with expected changes in exchange rates and vary more than expectations about future exchange rate movements. We interpret this evidence as being the result of the existence of a band of "agnosticism" within which movements of current exchange rates have little or no informational content about the market's expectations of future exchange rate movements.