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Uncertainty and risk premium puzzle

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  • Heeho Kim

Abstract

This paper provides a theory and evidence that the risk premium puzzle may be viewed mainly as a phenomenon pertaining to the unstable foreign exchange market. In an unstable market, errors uncompensated by an initial risk premium accrue due to consumer expectation revision about the ex ante uncertainty of the exchange rate. These revision errors are different from the forecasting errors, depending on the frequency of the consumer expectation revision and the degree of risk aversion. A simulation was discussed on how the risk premium actually deviates from an initial premium in the unstable market. Using the monthly data of the U.K., Japan, Australia, Korea, Malaysia, and Thailand from January 1994 to December 2008, it is shown that revision errors for risk premium were statistically significant and were non-trivial in magnitude and that the degree of absolute risk aversion went up during the Asian currency crisis as well as the recent financial crisis periods. Copyright Springer Science+Business Media, LLC 2013

Suggested Citation

  • Heeho Kim, 2013. "Uncertainty and risk premium puzzle," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 37(1), pages 62-79, January.
    • Handle: RePEc:spr:jecfin:v:37:y:2013:i:1:p:62-79
    DOI: 10.1007/s12197-010-9170-7
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    3. Yutaka Kurihara, 2015. "Are Japanese Stock Prices Important Deterministic Elements of Exchange Rate Returns?," Bulletin of Applied Economics, Risk Market Journals, vol. 2(2), pages 1-9.
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    More about this item

    Keywords

    Revision Error; Risk Aversion; Premium Puzzle; Forward Premium Anomaly; F31; G10; G15;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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