International Capital Markets and Foreign Exchange Risk

Relations between foreign exchange risk premia, exchange rate volatility, and the volatilities of the pricing kernels for the underlying currencies, are derived under the assumption of integrated capital markets. As predicted, the volatility of exchange rates is significantly associated with the estimated volatility of the relevant pricing kernels, and foreign exchange risk premia are significantly related to both the estimated volatility of the pricing kernels and the volatility of exchange rates. The estimated foreign exchange risk premia mostly satisfy Fama's (1984) necessary conditions for explaining the forward premium puzzle, but the puzzle remains in several cases even after taking account of the pricing kernel volatilities.