Modeling the horizon-dependent ex-ante risk premium in the foreign exchange market: Evidence from survey data

► The ex-ante risk premium is determined as the solution of a two-country portfolio asset pricing model. ► We measure the 3- and 12-month ahead JPY/USD and GBP/USD ex-ante risk premia using Consensus Economics survey data. ► The unobservable net market positions estimated using Kalman filtering share similar trends with observed aggregate positions. ► The model explains the main fluctuations of the ex-ante risk premia. ► The ex-post market risk premium adjusts toward the ex-ante risk premium. Using Consensus Economics survey data on experts’ expectations, we aim to model the 3- and 12-month ahead ex-ante risk premia on the JPY/USD and the GBP/USD exchange markets. For each market and at a given horizon, we show that the risk premium is well determined by the conditional expected variance of the change in the real exchange rate, agents’ real NMP in assets and a constant composite risk aversion coefficient, as suggested by a two-country portfolio asset pricing model. The expected variance depends on the past values of the observed variance and the unobservable real NMP is estimated as a state variable using the Kalman filter methodology. We found that the trends of our estimated horizon-specific NMPs are consistent with the ones of the observed short term aggregate NMPs calculated using the U.S. Treasury International Capital System dataset. Moreover, we show that the ex-post premia tend to adjust toward the ex-ante values, suggesting that experts’ beliefs provide a relevant information to the market. These results bring new responses to the difficulties reported by the widespread ex-post risk premium literature and enhances the usefulness of survey data in modeling the risk premium.