Journal of Multinational Financial Management

9 (1999) 291 316

www.elsevier.com/locate/econbase

Time-varying risk premia in foreign exchange

and equity markets: evidence from AsiaPacific
countries
Chu-Sheng Tai *
Department of Economics, The Ohio State Uni6ersity, Columbus, OH 43210, USA
Received 15 July 1998; accepted 26 February 1999

Abstract
This paper examines the validity of the risk premia hypothesis in explaining deviations
from Uncovered Interest Parity (UIP) and the role of deviations from Purchasing Power
Parity (PPP) in the pricing of foreign exchange rates and equity securities in five Asia Pacific
countries and the US. Using weekly data from 1 January, 1988 to 27 February, 1998, I find
that conditional variances are not related to the deviations from UIP in any statistical sense
based on an univariate GARCH(1,1)-M model. As I consider both foreign exchange and
equity markets together and test a conditional international CAPM (ICAPM) in the absence
of PPP, I cannot reject the model based on the J-test by Hansen (Econometrica 50 (1982),
10291054) and find significant time-varying foreign exchange risk premia present in the
data. This empirical evidence supports the notion of time-varying risk premia in explaining
the deviations from UIP. It also supports the idea that the foreign exchange risk is not
diversifiable and hence should be priced in both markets. 1999 Elsevier Science B.V. All
rights reserved.
Keywords: International asset pricing; Uncovered interest parity; Foreign exchange risk premium
JEL classification: F31; G12; C32

* Corresponding author. Tel.: +1-614-2922639; fax: +1-614-2923906.

E-mail address: tai.13@osu.edu (C.-S. Tai)
1042-444X/99/$ - see front matter 1999 Elsevier Science B.V. All rights reserved.
PII: S 1 0 4 2 - 4 4 4 X ( 9 9 ) 0 0 0 0 4 - 3

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C.-S. Tai / J. of Multi. Fin. Manag. 9 (1999) 291316

1. Introduction
One dimension that distinguishes domestic finance from international finance is
foreign exchange risk. The increasing globalization has promoted investors to
allocate a significant portion of their portfolio holdings in foreign assets in order to
earn significant benefits from international diversification. To manage the risk of
international portfolios, portfolio managers might want to know whether foreign
exchange risk is a priced factor, which has direct implication for hedging strategies.
Foreign exchange risk pricing is also important to corporate financial managers. If
exchange risk is not priced in the equity markets, corporate hedging is not
justifiable since investors are not willing to pay a premium for firms with active
hedging policies, e.g. Dufey and Srinivasulu (1983), Smith and Stulz (1985) and
Jorion (1991). Utilizing Rosss arbitrage pricing theory (APT) (Ross, 1976), Jorion
(1991) fails to find significant foreign exchange risk premia in the US stock market.
However, Choi et al. (1998) find that foreign exchange risk is priced in the Japanese
stock market. In an international context, Ferson and Harvey (1994), Korajczyk
and Viallet (1992), Dumas and Solnik (1995) all find that foreign exchange risk is
a priced factor.
Another body of literature in international finance has focused on the efficiency
of foreign exchange market since the breakdown of the Bretton Woods system of
fixed exchange rates in 1973. One important building block to many models used in
testing market efficiency is the hypothesis of uncovered interest parity (UIP). This
hypothesis states that if interest rate differential is different from the expected rate
of change of the exchange rate, risk neutral agents tend to move their uncovered
funds across financial markets until equality is re-established. Thus, under the
standard assumption of rational expectations, and risk neutral agents, the ex post
excess returns of holding foreign currency deposits just equal the market true
expected excess returns plus a forecast error that is unpredictable ex ante. One
important conclusion coming out of this research is that there exist predictable
components in excess returns of holding foreign currency deposits. This predictable
excess return is one of the puzzles in international finance literature.1 Two possible
sources of explanations have been proposed to account for this puzzle. First, the
assumption of rational expectations is violated and hence agents make systematic
forecast errors.2 Second, agents are not risk neutral, and thus demand a risk

1
See Hodrick (1987), Cumby (1988), Korajczyk and Viallet (1992), Bekaert and Hodrick (1993),
Lewis (1994).
2
For example, Bilson (1981), Meese (1986), Frankel and Froot (1987) argue that agents systematically
make mistakes in predicting exchange rates, and reject rational expectations. Obstfeld (1986), Lewis
(1988), Kaminsky (1993) suggest that even if expectations are fully rational ex ante, exchange rate
forecast may appear biased and serially correlated in the ex post sample if there is the possibility of a
major policy change, which is the so called peso problem. McCallum (1994) argues that monetary
authorities manage interest rates so as to smooth their movements, while also resisting changes in
exchange rates that creates a wedge between the nominal interest rate differentials and expected rate of
change in exchange rates.

C.-S. Tai / J. of Multi. Fin. Manag. 9 (1999) 291316

293

premium when holding risky assets.3 For example, Fama (1984), Hansen
and Hodrick (1980, 1983), Hodrick and Srivastava (1984), Korajczyk (1985),
Cumby (1988), Mark (1985, 1988), Kaminsky and Peruga (1990) all conclude
that forward rates differ from expected future spot rates by a time-varying
risk premium.4 Since the zero risk premium is hardly compatible with the
existing applied finance literature, this time-varying risk premium argument
has led to an intensive search for proper specification of the risk premium in
the foreign exchange market. However, empirical research has failed to demonstrate a measure of foreign exchange risk that can account for observed predictable components in foreign exchange, or which is even priced.5 Two possible
reasons may account for this failure. First, most empirical work seeking to
apply asset pricing models to foreign exchange has continued to focus on
models which assume purchasing power parity (PPP).6 However, many authors
have shown that the violation of PPP is a norm although PPP tends to hold in
the long run. In the absence of PPP resulting from either different consumption tastes or violation of the law of one price (LOP), investors from different
countries face different prices of goods. In this situation, international asset
pricing model will contain risk premia which are related to the covariances of
asset returns with exchange rates, besides the traditional market risk premium.7
As a result, in order to seriously address the issue of pricing of foreign exchange
risk, an asset pricing model that incorporates deviations from PPP is required.
Second, previous empirical tests for foreign exchange risk premia have focused
mainly on foreign exchange markets and ignored international equity markets
except Giovannini and Jorion (1987, 1989), Bekaert and Hodrick (1992), Korajczyk
and Viallet (1992), Dumas and Solnik (1995). As mentioned earlier, the increasing
globalization has attracted domestic investors to hold foreign assets in order to
reduce systematic risk. Consequently, investors tend to hold different kinds of
assets in international financial markets rather than just foreign currencies. Thus,
one should not isolate foreign exchange markets from other asset markets when
testing international asset pricing models. As pointed out by Giovannini and Jorion
(1987) a joint test should be more powerful than the existing work that looks at two
sets of assets separately.8

Of course, if the underlying risk is diversifiable, there will be no risk premium.

If covered interest parity (CIP) holds, the deviations from UIP can be expressed as the difference
between expected future spot rates and current forward rates (i.e. forward bias or forward forecast
error).
5
Engel (1996) provides a detailed survey on this issue.
6
Examples of papers examining pricing of forward contracts under PPP include Mark (1988), Cumby
(1988), Korajczyk and Viallet (1992).
7
See Solnik (1974), Stulz (1981), Adler and Dumas (1983), Hodrick (1981).
8
Examples that look at only equity market include Stehle (1977), Korajczyk and Viallet (1989),
Cumby and Glen (1990), Harvey (1991), Chan et al. (1992), Ferson and Harvey (1993), etc. Examples
that look at foreign currency include Hansen and Hodrick (1983), Mark (1985, 1988), Cumby (1988),
Levine (1989), Baillie and Bollerslev (1990), McCurdy and Morgan (1991), Backus et al. (1993), etc.
4

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C.-S. Tai / J. of Multi. Fin. Manag. 9 (1999) 291316

Because of the importance of foreign exchange risk pricing mentioned above

and its inconclusive empirical findings, the goal of this paper is to examine the
validity of the (time-varying) risk premia hypothesis and the role of deviations from
PPP in the pricing of foreign exchange rates and equity securities in five Asia
Pacific countries and the US. Specifically, I first apply an univariate GARCH(1,1)
in Mean (GARCH(1,1)-M) model to jointly test for time-varying risk premia and
rational expectations in those markets from the perspective of a representative
Japanese investor. Then, I apply generalized method of moments (GMM) methodology (Hansen, 1982) to empirically estimate and test international asset pricing
models in the absence of PPP under both unconditional and conditional frameworks.9 Using weekly data from 1 January, 1988 to 27 February, 1998, I find that
conditional variances are not related to deviations from UIP in any statistical sense
based on the univariate GARCH(1,1)-M model. As I consider both foreign
exchange and equity markets together and test a conditional international CAPM
in the absence of PPP, I can not reject the model based on the J-test by Hansen
(1982), and find significant time-varying foreign exchange risk premia present
in the data. This empirical evidence supports the notion of time-varying risk
premia in explaining the deviations from UIP. It also supports the idea that the
foreign exchange risk is not diversifiable and hence should be priced in both
markets.
This paper is divided in the following manner. Section 2 exposes the GARCH
model for testing the joint hypothesis of risk premium and rational expectations.
Section 3 motivates the international CAPM (ICAPM) specification for the timevarying risk premium and presents the econometric methodology used to test the
ICAPM. Section 4 discusses the data. Section 5 reports the empirical results. The
last section concludes.

2. The risk premium and rational expectations

The UIP hypothesis postulates an equilibrium relationship that can be expressed
as
it i*t = Et (st + 1) st [ ert + 1 = E(st + 1) st + i*
it + ot + 1 = Et (ert + 1)+ ot + 1
t
(1)
where st is the (log of the) exchange rate, expressed as the dollar price of one unit
of foreign currency; i *t is the (log of one plus) foreign interest rate; it is the (log of
one plus) domestic interest rate; ert + 1 is the realized excess return on foreign
currency; ot + 1 =st + 1 Et (st + 1) is the statistical forecast error, and Et () is the
statistical expectations operator conditional on time t information. The UIP
hypothesis states that expected excess returns, Et (ert + 1), to uncovered currency
9
I use unconditional to mean risk premia are time-invariant, whereas conditional means risk
premia are time varying.

C.-S. Tai / J. of Multi. Fin. Manag. 9 (1999) 291316

295

speculation are zero. If expected excess returns are zero, then in a large sample
realized excess returns should be unpredictable. In other words, under the assumption of rational expectations, the forecast errors are assumed to be unpredictable
given information available at the time the forecast is made, so that ot + 1 is
orthogonal to any information available at time t. Under risk neutrality, a finding
of nonzero ex ante excess returns to currency speculation is consistent with market
inefficiency.10 However, under risk aversion, a finding of nonzero ex ante excess
returns does not necessarily imply market inefficiency since it is consistent with a
risk premium argument provided that rational expectations hold. Thus, due to this
joint nature of tests for market efficiency and for the presence of a risk premium,
researchers often assume either that expectations are rational and test for the
presence of a risk premium, or assume no risk premium and test for rational
expectations.
To preserve the joint nature of the hypothesis testing, I consider following
GARCH(1,1)-in-Mean model, which was introduced by Bollerslev (1986) as a
generalized class of ARCH-in-Mean models.
ert + 1 =RPt +b1ert +b2ert 1 + b3ert 2 + b4ert 3 + ot + 1

(2)

RPt =a0 +a1

ht + 1

(3)

ht + 1 =c0 +c o +c2ht

(4)

ot + 1Ft GED(0,ht + 1, 6)

(5)

2
1 t

In Eq. (2), the information variables available at time t are used to test for rational
expectations. If the null hypothesis, H0:b1 = b2 = b3 = b4 = 0, is rejected, then the
rational expectation hypothesis is not justified in estimates of Eq. (2). The formulation of the risk premium (RPt ) follows Domowitz and Hakkio (1985) which is
defined in Eq. (3) where ht + 1 is the conditional component of the variance of the
error term ot + 1. The conditional density function defined in Eq. (5) is modeled as
a Generalized Error Distribution (GED) to take the leptokurtosis found in most
financial data including exchange rates into account.11 Thus, the risk premium has
a constant component (a0) and a time varying component, which is the standard
deviation of the conditional variance (
ht + 1). If both a0 and a1 are insignificantly
different from zero, there is no risk premium. If a0 " 0 but a1 " 0, there is a
constant premium. If a1 "0, this is evidence of a time-varying risk premium.
The GARCH(1,1)-M model has been chosen to incorporate heteroskedasticity
into the estimation procedure. To estimate Eqs. (2)(4) under conditional GED
with n degrees of freedom, I use quasi-maximum likelihood estimation (QML)
proposed by Bollerslev and Wooldridge (1992) which allows inference in the
presence of departures from conditional normality. Under standard regularity

10

This argument is based on the implicit assumption of a perfect capital market.

The GED is a generalization of the normal distribution. It includes the normal distribution if the
parameter 6 has a value of 2. 6 is a measure of tail-thickness. If 6 B 2 a fat-tailed distribution results. The
lower limit for 6 is 0. If 6 B 1, the unconditional variance does not exist.
11

C.-S. Tai / J. of Multi. Fin. Manag. 9 (1999) 291316

296

conditions, the QML estimator is consistent and asymptotically normal and statistical inferences can be carried out by computing robust Wald statistics. The QML
estimates can be obtained by maximizing likelihood function, and calculating a
robust estimate of the covariance of the parameter estimates using the matrix of
second derivatives and the average of the period-by-period outer products of the
gradient. Optimization is performed using BFGS algorithm.

3. International capital asset pricing model (ICAPM)

3.1. The conditional ICAPM

In deriving the ICAPM of Adler and Dumas (1983), we begin with the classic
CAPM. The classic CAPM says that, in equilibrium, there must exist two numbers,
h and u, such that, for all securities i 12:
E(ri ) =h +ucov(ri, rm )

(6)

where ri is the real rate of return on security i; rm is the real rate of return on the
market portfolio; h is the real rate of return on a zerobeta portfolio, and u is the
market average degree of risk aversion. Since the real rate of return is unobservable,
we can transform it into a nominal rate of return. The real rate of return, ri, is
given by:
ri =

1 + Ri
1
1+p

(7)

where Ri is the nominal rate of return and p is the rate of inflation.

Suppose both security prices and general price indices follow stationary Ito
processes (i.e. geometric Brownian motion):
Ri dt =
pi dt =

dPi
=E(Ri ) dt + si dwi
pi

(8)

dIi
=E(pi ) dt +sp dzp
Ii

where pi is the price of security i; E(Ri ) is the instantaneous nominal expected rate
of return on security i; si is the instantaneous standard deviation of the nominal
return on security i; wi is a standard Wiener process and dwi is the associated white
noise; Ii is the general price index; E(pi ) is the expected value of the instantaneous
rate of inflation; sp is the standard deviation of the instantaneous rate of inflation;
zp is a standard Wiener process, and dzp is the associated white noise. We can
substitute Eqs. (7) (9) into Eq. (6) and apply Itos lemma to obtain
E(Ri ) E(p) +var(p) cov(Ri, p)= h+ u cov(Ri p, Rm p)

(9)

12
The derivation of the ICAPM is based on Dumas (1994). For more details of deriving the ICAPM,
see Adler and Dumas (1983).

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297

Expanding the cov(Ri p, Rm p), and rearranging terms:

E(Ri ) = h+E(p) (1 u)var(p) u cov(Rm, p)+ (1 u)cov(Ri, p)
+ u cov(Ri, Rm )

(10)

In Eq. (10), the first four terms of the right-hand side sum to nominally risk-free
rate of return, R, if it exists. Thus, we can rewrite Eq. (10) in the following form:
E(Ri ) = R +(1 u)cov(Ri, p)+ u cov(Ri, Rm )

(11)

Eq. (11) is a nominal CAPM which indicates that uncertain inflation produces a
separate premium in nominal returns even if investors were risk neutral (u= 0).
Next we want to extend this nominal CAPM in an international setting. We can
measure the rate of inflation over a period in any country in any currency. Suppose
we choose the US dollar ($) as numeraire, then the rate of inflation in country l in
terms of $ can be expressed as following:13
p $l =(1 +p ll)(1 +e $l ) 1

(12)

where p is the rate of inflation in country l in dollar units and e is the relative
change in the spot exchange rate (dollar price of one unit local currency) over the
period. Similarly, the rate of return, Ri, of all securities expressed in foreign
currency units can be translated into dollar using following formula:
$
l

$
l

Ri =(1 +R li)(1 +e $l ) 1

(13)

where R li is the rate of return on security i expressed in the non-dollar currency and
e $l is the rate of change of the spot exchange rate expressed in dollars per unit of
non-dollar currency. The international nominal CAPM, expressed in dollars, can
now be derived in the following way. For each country l, a domestic nominal
CAPM similar to Eq. (11) holds:
E(Ri ) = R +(1 u l)cov(Ri, p $l )+ u l cov(Ri, R lp)

(14)

where R is the dollar, nominally risk-free interest rate and R lp = i x liRi (x li being the
weight allocated by investors of country l to security i ) is the dollar rate of return
on the optimal portfolio held by the investors of country l. In order to aggregate
Eq. (14) over all of the investor groups, we divide both sides of Eq. (14) by u l,
multiply them by W l (each countrys wealth), sum them over all national investor
groups, and finally divide them by l W l/u l, to get
cov(Ri, p $l )
1
+ u cov(Ri, Rm )
E(Ri ) = R +u % ( l 1)W l
u
W
l
where
W= % W l,
l

13

1
=
u

%W l/u l
l
,
W

In the empirical tests, I use Japanese yen as a base currency.

(15)

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C.-S. Tai / J. of Multi. Fin. Manag. 9 (1999) 291316

u l is the coefficient of relative risk aversion for investors from country l, and u is
an average of the risk aversion coefficients for each national group, weighted by the
corresponding relative wealth W l/W.
The international nominal CAPM (Eq. (15)), now contains as many inflation premia as there are national investor groups. Since the variability in
the exchange rate is much greater than the variability in the inflation rate, we
can assume that local inflation rate is nonrandom, which is the case of Solnik
(1974), then cov(Ri, p $l ) =cov(Ri, e $l ) because p ll + e $l = p $l .14 Consequently, in the
international CAPM, the foreign exchange risk becomes one of the systematic risks
under which PPP does not hold and local inflation rates are nonstochastic.
Consider the dollar rate of return from a foreign currency deposit, V $l , which is
given by:
V $l =(1 +V ll)(1 +e $l ) 1

(16)

Then, cov(Ri, e $l ) = cov(Ri, V $l V ll)= cov(Ri, V $l ) since the foreign nominal currency deposit rate in local currency units,V ll, is known at the time when the deposit
was made, and hence is nonrandom. Thus, we can rewrite Eq. (15) as
1
cov(Ri, V $l )
E(Ri ) = R +u % ( l 1)W l
+ u cov(Ri, Rm)
W
l u

(17)

Suppose there are L +1 countries and a set of N= n+ L+1 assetsother than

the measurement-currency depositwhich is composed of n equities, L nonmeasurement-currency deposits and the world portfolio of equities which is the Nth and
last asset. Since we are interested in the conditional tests of international CAPM,
we can rewrite Eq. (17) in its conditional form:
L

E[rit Vt 1]= % ll, t 1cov[rit, rn + l, t Vt 1]+ lm, t 1cov[rit, rmt Vt 1]

l=1

where lm, t 1 =ut 1 =

and

 

ll, t 1 = ut 1

(18)

1
W lt 1

1
and rit
ul
Wt 1

Wl
1
Ll= 1 t 1 l
Wt 1 u
is the nominal return on asset or portfolio i, i= 1 N, from time t1 to t, in excess
of the rate of interest of the currency in which returns are measured; rn + l, t is the
excess return on the nonmeasurement foreign currency deposit; rmt is the excess
return on the world market portfolio; ll, t 1, l =1 L, are the time-varying world
price of exchange rate risk; lm, t 1 is the time-varying world price of market risk,
and Vt 1 is the information set that investors use in forming their portfolios. The
international CAPM, Eq. (18), is the conditional version of Eq. (14) in Adler and
Dumas (1983) which takes into account the fact that investors of different countries
have different views about asset returns.
14
The relative PPP is expressed as p $US =(1 + p ll)(1 +e $l ) 1. If relative PPP holds, then p ll +e $l
p $US = 0. If relative PPP does not hold, then p ll +e $l p $US =u where u are the deviations from relative
PPP. If we assume local inflation is nonstochastic, then p $US =p ll =0. Thus, e $l =u which implies that the
rate of exchange rate change is equal to the deviations from relative PPP.

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299

3.2. Econometric methodology: The pricing kernel

The pricing kernel method, initiated by Hansen and Jagannathan (1991), was
generalized by Dumas and Solnik (1995) to test asset pricing models and will be
used in this paper. We know that the first-order condition of any consumerinvestors optimization problem can be written as:
E[Mt (1 + rf, t 1)Vt 1]= 1

(19)

E[Mtrit Vt 1]= 0

(20)

i =1 N

where Mt is the marginal rate of substitution between nominal return at date t and
at date t 1 and rf, t 1 is the conditionally riskfree rate of interest known at date
t1. Without specifying the form of Mt, Eq. (20) has little empirical content since
it is easy to find some random variable Mt for which the equation holds. Thus, it
is the specific form of Mt implied by an asset pricing model that gives Eq. (20)
further empirical content (see Ferson, 1995). The Mt for international CAPM in
Eq. (18) has the following form:

Mt = 1 l0, t 1 % ll, t 1rn + l, t lm, t 1rmt /(1+ rf, t 1)

l=1

(21)

where
L

l0, t 1 = % ll, t 1E[rn + l,t Vt 1] lm, t 1E[rm,t Vt 1]

l=1

The new time varying term, l0, t 1, appears as a way of ensuring Eq. (19) holds.For
econometric purposes, following Dumas and Solnik (1995) two auxiliary assumptions are needed:
Assumption 1: the information set Vt 1 is generated by a vector of instrumental
variables Zt 1. Zt 1 is a 1 K vector of predetermined instrumental variables that
reflect everything that is known to the investor at time t 1.
Assumption

2: l0, t 1 = Zt 180, ll, t 1 = Zt 18l, lm, t 1 = Zt 18m,

l= 1 L.

(22)

Here, the 8s are the time-invariant vectors of weights. Based on Eq. (19), we define
the innovation ut :
Mt (1 + rf, t 1) =1 ut

(23)

and given Assumption 2 and the definition of Mt in Eq. (21), we can write ut as:
L

ut =1 Mt (1 + rf, t 1) = Zt 180 + % Zt 18lrn + l, t + Zt 18mrmt

(24)

l=1

with ut satisfying:
E[ut Vt 1]= 0
Next, based on Eq. (20), we define the innovation hit :

(25)

C.-S. Tai / J. of Multi. Fin. Manag. 9 (1999) 291316

300

(26)

hit =rit ritut

with hit satisfying:
E[hit Vt 1]= 0

(27)

One can form the 1 +N vector of residuals ot = (ut, ht ). Combining Eqs. (25) and
(27) under Assumption 1 yields:
E[ot Zt 1]= 0

(28)

It follows that
E[ ft (b0)] =E[Z t 1ot ]= 0

for

t= 1, 2 T

(29)

where Zt 1 is a 1 K vector and ot is a 1 (1+ N) vector and T is the number of

observations over time. Thus, there are K (1+N) moment conditions. One can
test these moment restrictions implied by the theory using Hansens test of the
orthogonality conditions used in the estimation (Hansen, 1982).

4. Data and summary statistics

Most of the empirical literature concerning the efficiency of foreign exchange
markets and international equity markets is based on exchange rate vis-a`-vis the US
dollar. This implies that not all reported results are necessarily independent of each
other. Thus, it is interesting to investigate foreign exchange risk premia based on
some other base currencies and compare the results with previous findings using the
US dollar as a base currency. In addition, due to the facts that lots of the empirical
studies have been done in developed countries and that developing countries start
to play an important role in the international financial markets, this paper focuses
on five Asia Pacific capital markets: Japan, Hong Kong, Singapore, Taiwan, and
Malaysia and one major developed market: the US. Among theses five AsiaPacific
capital markets, Japan is the largest capital market in terms of its market capitalization. Thus, Japanese yen is chosen to be the base currency.
I consider 12 assets (N =12), seven equity indices (n+ 1= 7) and five currency
deposits (L =5). The seven equity indices consist of six national indices (n= 6;
Hong Kong, Singapore, Taiwan, Malaysia, Japan, and the US) and one world
equity index (the 12th and last asset). These total return indices of national equity
markets are from Morgan Stanley Capital International Perspective (MSCI). The
five currency deposits are Hong Kong 1-week deposit (HKDEP1W), Singapore
1-week deposit (SNGDP1W), Taiwan 10-day money market (TAMM10D),
Malaysia 1-month deposit (MYDEP1M), and Eurodollar 7-day deposit rate
(ECUDS1M).15 Thus, there are five exchange rate risk premia in the international
CAPM. Observations are sampled at weekly intervals. The excess return on an
15
The data on one-week currency deposit rates for Taiwan and Malaysia are not available, so a
10-day money market rate and one-month deposit rate are used for Taiwan and Malaysia, respectively.

C.-S. Tai / J. of Multi. Fin. Manag. 9 (1999) 291316

301

equity market is the log difference of total return index in excess of 7-day Euroyen
interest rate. The excess return on a currency holding (i.e. weekly deviations from
UIP) is the 7-day interest rate of that currency compounded by the rate of change
of the spot exchange rate in excess of the 7-day Euroyen interest rate.
The selection of instruments draws on previous studies. Harvey (1991) shows that
US information variables are useful in predicting foreign equity returns. Giovannini
and Jorion (1987), Bekaert and Hodrick (1992) find that nominal interest rates have
explanatory power for the time variation of currency returns. Thus, Five instruments are chosen in this study. They are the lagged world excess equity return
(WORLD), the dividend yield on S&P 500 index in excess of the 7-day Euroyen
deposit rate (DIV),16 the change in the US term premium, measured by the yield on
the 10-year US Treasury note in excess of the 7-day Euroyen deposit rate (DUSTP),
the change in 7-day Euroyen deposit (DEUROY), and a constant. These variables
are linked to the business cycle and to changes in global uncertainty.17 The weekly
data ranges from January 1, 1988 to 27 February, 1998, which is a 531-data-point
series. However, I work with rates of return and use the first difference of
Table 1
Variable definitions and notations (weekly data: 01/22/8802/27/98: 528 observations)
Variable

Notation

MSCI
MSCI
MSCI
MSCI
MSCI
MSCI
MSCI

MSUSAM
MSJPAN
MSHGKG
MSSING
MSTAIW
MSMALY
MSWRLD

USA total return index

Japan total return index
Hong Kong total return index
Singapore total return index
Taiwan total return index
Malaysia total return index
World total return index

Foreign currency deposit rates

EURO-currency (LDN) US$ 7 daymiddle rate
EURO-Currency (LDN) Japan 7 daymiddle rate
Hong Kong Deposit 1 week-middle rate
Singapore Deposit 1 week-middle rate
Taiwan Money Market 10 day-middle rate
Malaysia Deposit 1 month-middle rate

ECUSD7D
ECJAP7D
HKDEP1W
SNGDP1W
TAMM10D
MYDEP1M

Information 6ariables
S&P 500 COMPOSITEdividend yield
US Treasury Constant Maturities 10-year
S&P 500 dividend in excess of 7-day Euroyen rate: S&PCOMPECJAP7D
The change in the 7-day Euroyen deposit rate: ECJAP7D(t)ECJAP7D(t1)
First difference of the change in US term premium:D(FRTCM10ECJAP7D)
Lagged Return on MSCI world total return index

S&PCOMP
FRTCM10
DIV
DEUROY
DUSTP
WORLD

16
The data on Japanese dividend yield is not available, so I use dividend yield on S&P500 and convert
it into Japanese yen using corresponding weekly yen/$ spot rate.
17
See Fama and French (1989).

302

C.-S. Tai / J. of Multi. Fin. Manag. 9 (1999) 291316

information variables which have to be translated from US dollar into

Japanese yen, and finally all the instruments are used with a 1-week lag,
relative to the excess return series; that leaves 528 observations expanding
from 22 January, 1988 to 27 February, 1998. Table 1 describes the variables and notations used in this paper. All the data are obtained from
DATASTREAM.
Panel A of Table 2 contains summary statistics for the data. Not surprisingly,
the excess returns on the equity indices have higher mean returns, but also
higher volatility than the excess returns on the currency deposits. In terms of
Sharpe ratio, the US has the highest ratio in equity return (0.1098), and Singapore
has the highest ratio in currency return (0.0319). Overall AsiaPacific financial
markets may be characterized as high-return and high-volatility markets. The
coefficients of skewness and excess kurtosis reveal nonnormality in the data.
This is consistent with previous findings that both stock and currency returns
are not normally distributed and have a comparatively fat tailed distribution. GARCH model is developed for the purpose of capturing this nonnormal distribution and will be applied to test time-varying risk premium and
rational expectations jointly in the next section. The last two columns in Panel A of
Table 2 report the Ljung Box portmanteau test statistics for independence in the
return and squared return series up to 24 lags, denoted by Q(24) and Q 2(24)
respectively.18 The hypothesis of linear independence is not rejected at 10% level for
all equity returns, but is rejected for all currency returns at 5% level except for New
Taiwan dollar. Independence of the squared return series is rejected for all return
series at 5% level except for Singapore dollar and New Taiwan dollar. Clearly, the
nonlinear dependencies are much prevalent than the linear dependencies. Both these
linear and nonlinear dependencies will be taken into account by the GARCH
model.
Panel B reports the summary statistics for the instruments. The correlation matrix of the instruments in Panel C shows that the selected variables
contain sufficiently orthogonal information.19 To insure all the return series
and instrumental variables are stationary, I conduct two unit root tests: augmented Dickey Fuller (ADF) and PhillipsPerron (PP). All the test results
reject the null hypothesis of unit root nonstationarity, and hence all the variables used in this study are considered as stationary satisfying the GMM assumption.20

The formula for the LjungBox statistic is, LB(k) =T(T+ 2)kj= 1r 2j /T j where rj is the jth lag
autocorrelation, k is the number of autocorrelations, and T is the sample size (Ljung and Box (1978)).
19
The instruments used by Dumas and Solnik (1995) are highly correlated thus may not contain
enough orthogonal information in their study.
20
The results of unit root tests are not reported here, but are available upon request.
18

Table 2
Summary statistics for excess returns and instrumentsa
Mean

SD

SHP

Q(24)

Q 2(24)

3.9100***

25.0579

169.5870***

0.3351***

9.6692***

8.8004

140.2499***

Minimum

Maximum

Skewness

0.1154

0.1069

0.6861***

0.1940

0.2212

Kurtosis

Panel A: Excess equity and currency returns

MSUSAM

0.0238

0.00111

0.0358

MSHGKG

0.00262

0.0409

0.0645

0.3490

0.2492

0.3452***

16.2434***

16.5821

78.9340***

MSSING

0.00123

0.0341

0.0366

0.2207

0.2201

0.0230

13.8414***

20.9733

176.7243***

MSTAIW

0.00173

0.0636

0.0272

0.4300

0.3877

0.1481

13.4483***

17.7231

196.0677***

MSMALY

0.00065

0.0444

0.0152

0.3356

0.3976

0.0922

23.1050***

28.6745

112.3876***

ECUSD7D
HKDEP1W

0.00049
0.00031

0.0146
0.0146

0.0316
0.0232

0.0429
0.0513

0.0531
0.0457

0.4824***
0.4691***

1.1005***
0.9774***

45.2884***
45.4548***

40.2305**
43.9899***

SNGDP1W
TAMM10D
MYDEP1M

0.00039
0.00035
0.00032

0.0133
0.0155
0.0188

0.0319
0.0226
NA

0.0496
0.0519
0.1532

0.0412
0.0714
0.1039

0.6097***
0.23585**
1.2055***

1.4686***
1.2603***
13.8179***

39.1617**
28.8318
70.9687***

35.8026*
27.9724
331.6159***

0.00141

0.0231

0.0621

0.1177

0.1090

0.3220***

4.9618***

16.6046

146.2610***

MSJPAN

MSWRLD

Panel B: Instruments
Mean
DIV
DEUROY
DUSTP

0.00015
1.1E06
0.00007

SD
0.01464
0.00007
0.02094

0.1098
NA

Minimum

Maximum

0.05190
0.00043
0.08330

0.04425
0.00044
0.08123

C.-S. Tai / J. of Multi. Fin. Manag. 9 (1999) 291316

0.00259

303

304

Panel C: Unconditional correlation

DIV
DEUROY

DUSTP

DIV
DEUROY
DUSTP
WORLD

1
0.3691

1
0.0295
0.7046
0.0515

1
0.0551
0.0227

WORLD

a
SHP is the Sharpe ratio. Q(24) and Q 2(24) are the LjungBox test statistics for serial correlation in the excess returns and excess returns squared,
respectively.
* Statistically significant at the 10% level.
** Statistically significant at the 5% level.
*** Statistically significant at the 1% level.

C.-S. Tai / J. of Multi. Fin. Manag. 9 (1999) 291316

Table 2 (Continued)

C.-S. Tai / J. of Multi. Fin. Manag. 9 (1999) 291316

305

5. Empirical results

5.1. Distinguish rational expectations from (time-6arying) risk premia:

GARCH(1,1) -M
The presence of linear dependencies suggests that the conditional mean of the
distribution of returns is a function of either past residuals or past returns. Based
on the rational expectations assumption, all information available at time when
forecast is made should be uncorrelated with forecast errors.21 Thus, if lagged and
current forecast errors and/or public available information can help in predicting
future forecast errors, this is evidence of irrationality or market inefficiency under
risk neutrality. However, most investors are risk averse and hence demand a risk
premium when holding uncovered foreign currency.22 The presence of second-moment dependencies suggests that the conditional variance of returns is time-dependent and heteroskedastic. Following Bollerslev (1986), I specify the conditional
variance of returns as a GARCH(p, q) process and assume that the possible
time-varying risk premia is due to this time-varying volatility in the second moment
of the distribution of excess returns. In my empirical tests, the GARCH(1,1)-M
model is chosen to fit the data.23 As indicated in Section 2, rational expectations
will be rejected if the null hypothesis, H0:b1 = b2 = b3 = b4 = 0, is rejected. On the
other hand, a significant a1 coefficient indicates the presence of time-varying risk
premium, and a significant a0 coefficient provides the evidence of constant risk
premium in foreign exchange markets. The results are shown in Table 3. Based on
the robust Wald statistics, the rational expectations hypotheses are rejected for
Singapore dollar, New Taiwan dollar and Malaysian Ringgit at 1% level and are
not rejected for the US dollar and Hong Kong dollar. This implies that the foreign
exchange markets for Singapore, Taiwan and Malaysia do not appear to be efficient
in a rational sense since the coefficients on the past forecast errors are statistically
significant. As far as the risk premium is concerned, I only find weak evidence of
time-varying risk premium for the New Taiwan dollar at 10% level, and there is no
evidence supporting the presence of constant and time-varying risk premia for the
other four currencies. These results are consistent with Domowitz and Hakkio
(1985) where they can not reject the null hypothesis of no risk premium for
currencies of five industrial countries based on an ARCH-in-Mean model, and with
Baillie and Bollerslev (1990) where they utilize a multivariate GARCH approach to
model the time-varying risk premia and fail to find significant time-varying risk
premia for four European currencies. Based on their findings, Baillie and Bollerslev

21

Under CIP and UIP, the forward forecast error is equivalent to the deviation from UIP, which is
the excess return from foreign currency speculation.
22
If foreign exchange risk is diversifiable, then there will be no risk premium even investors are risk
averse.
23
Eqs. (2)(4) were estimated jointly with different specifications for p and q. No lags exceeding p =1
and q= 1 were found to be significant.

C.-S. Tai / J. of Multi. Fin. Manag. 9 (1999) 291316

306

Table 3
Estimation of GARCH(1,1)-M modela,b
Parameter

ECUSD7D

HKDEP1W

SNGDP1W

TAMM10D

MYDEP1M

a0

0.0003
(0.0233)
0.0067
(0.0066)
0.0329
(0.5325)
0.0797
(1.6348)
0.0893
(1.9099)*
0.0349
(0.6723)
0.0001
(0.9710)
0.1782
(2.7664)***
0.2156
(0.3298)
1.3227
(10.1587)***
0.3937
0.7436
1500.4516
0.3957
7.6648
74.9357***
28.1112
19.1097

0.0040
(0.2990)
0.3549
(0.3789)
0.0076
(0.1331)
0.1089
(1.8848)*
0.1029
(2.1754)**
0.0256
(0.6153)
0.0001
(1.4221)
0.1679
(1.9084)*
0.3321
(0.8211)
1.3575
(9.9912)***
0.5000
1.0001
1498.4396
4.0042
7.7348
66.8170***
25.7880
18.4634

0.0151
(0.7887)
1.2577
(0.8595)
0.0081
(0.0840)
0.1251
(2.9370)***
0.1123
(1.8791)*
0.0233
(0.5900)
0.0000
(1.4687)
0.0866
(1.3951)
0.7029
(3.8979)***
1.1803
(7.1493)***
0.7895
2.9324
1556.5834
2.6158
22.5627***
97.7892***
19.2743
12.3079

0.0035
(0.4439)
0.1488
(0.2825)
0.0514
(1.0588)
0.0619
(1.3534)
0.1102
(2.9231)***
0.0541
(1.4207)
0.0002
(2.2583)**
0.1753
(2.7803)***
0.1091
(0.3673)
1.3572
(10.4949)***
0.2844
0.5513
1464.5770
4.7900*
14.9456***
68.5185***
17.0873
20.2327

0.0016
(0.5239)
0.1553
(0.8081)
0.0325
(0.5836)
0.1307
(3.7823)***
0.0995
(2.6308)***
0.0237
(0.6713)
0.0000
(1.1237)
0.1123
(4.4911)
0.8611
(16.4341)***
1.2036
(14.2836)***
0.9734
25.6724
1465.9631
1.4844
19.5350***
243.1383***
20.8932
18.7728

a1
b1
b2
b3
b4
c0
c1
c2
n
c1+c2
HL
LIK
WALD1
WALD2
JB
Q(24)
Q 2(24)
a

ert+1 = RPt+b1ert+b2ert1+b3ert2+b4ert3+ot+1
RPt =a0+a1
ht+1
ht+1 = c0+c1o 2t +c2ht
ot+1FtGED(0,ht+1, n).
b

Robust t-statistics are given in parentheses. LIK is the maximum log-likelihood value. WALD1 is
the Wald statistics for H0:a0 = a1 = 0, WALD2 is the Wald test statistics for H0:b1 =b2 =b3 =b4 =0.
HL is the half-life of a shock measured in weeks. Q(24) and Q 2(24) are the LjungBox test statistics for
serial correlation in the standardized residuals and their squared values. Jarque-Bera test (JB) tests them
on normality.
* Statistically significant at the 10% level.
** Statistically significant at the 5% level.
*** Statistically significant at the 1% level.

C.-S. Tai / J. of Multi. Fin. Manag. 9 (1999) 291316

307

(1990) argue that the forward market efficiency is possibly violated either due to
inefficient processing of information by market participants, so that marked
deviations from rationality occur, or alternatively that other theoretical models to
explain time-varying risk premia are required. The results for the conditional
variance equations indicate significant ARCH effects for the US dollar, Hong Kong
dollar and New Taiwan dollar and GARCH effect for Singapore dollar and
Malaysian Ringgit according to the coefficient estimates of cs. Volatility persistence, measured by the sum of c1 and c2, is greater than 0.5 except for the US dollar
and New Taiwan dollar indicating a high degree of volatility persistence. A more
intuitive way of measuring volatility persistence is the half-life (HL) of a shock
calculated as HL=log(0.5)/log(c1 + c2). The HLs for Hong Kong dollar, Singapore dollar, and Malaysian Ringgit are greater than one week, but they are less
than 1 week for the US dollar and New Taiwan dollar. This implies that most
shocks last more than one week for most of AsiaPacific foreign exchange markets.
To assess the robustness of the results and the adequacy of the model, I conduct
diagnostic tests based on the standardized residuals of the model. The LjungBox
portmanteau test statistics for independence in the standardized residuals are
calculated using autocorrelations up to 24 lags. None of Q(24) and Q 2(24) test
statistics is significant at conventional significance levels, so the univariate
GARCH(1,1)-M seems to be an adequate model in capturing the linear and
nonlinear dependencies found in the data. The Jarque-Bera tests reject the hypothesis of normality for all series of standardized residuals. This evidence against
normality warrants the use of QML inferential procedures in the analysis.
In summary, the GARCH(1,1)-M model with a conditional GED distribution
does not provide any evidence of time-varying risk premia rather it points to a
violation of rational expectations hypothesis for some foreign exchange markets.
However, the insignificant risk premium coefficients found in all markets may result
from either a poor measure of risk or the misspecification of the model. In other
words, the conditional standard deviation may not be the proper measure of risk or
the univariate GARCH(1,1)-M is not a proper econometric model in modeling the
risk premium.24 Therefore, before all possible empirical models have been explored,
it is premature to abandon the risk premium interpretation of the unbiased forward
rate hypothesis or the deviations from UIP. As a result, I turn to the theoretical
international capital asset pricing model (ICAPM) derived in Section 3 and
empirically test it for the presence of time-varying risk premia.

5.2. Estimation and tests of ICAPM

5.2.1. Unconditional tests of ICAPM
In this section, I estimate the unconditional versions of the two contending
ICAPMs by setting Z = 1 in Eq. (22). The results of these two separate estimations
24
Although no GARCH in mean effect is found in a purely time-series model, namely univariate
GARCH(1,1)-M, several studies have successfully found significant time-varying risk premia in both
equity and foreign exchange markets when applying multivariate GARCH(1,1)-M model with asset
pricing restrictions. (De Santis and Gerard (1997, 1998), Tai (1998)).

308

C.-S. Tai / J. of Multi. Fin. Manag. 9 (1999) 291316

Table 4
Unconditional one-factor ICAPMa,b,c,d
Price of risk

Coefficient

t-statistic

l0
lm

0.0037
0.0254

0.6820
1.3760

E[rit Vt1] = lm cov[rit, rmt Vt1].

The GMM test is based on the moment condition in Eq. (29) with the instrumental variables reduced
to Z= 1.
c
The new term, l0, appears as a way of ensuring that Eq. (19) holds.
d
Test of overidentifying restrictions: J = 156.4121 x2 with 11 d.f. (critical value: x 2(0.05, 11) =19.675).
a

are shown in Tables 4 and 5. In Table 4, the unconditional ICAPM in which the
market risk proxied by MSCI world equity index is the only systematic risk is
rejected (x 211 =156.41) by the J-test with a P-value of zero. This result is different
from previous studies of Cumby and Glen (1990), Harvey (1991), Ferson and
Harvey (1994), Dumas and Solnik (1995) where they find that the MSCI world
equity index is mean-variance efficient using monthly equity returns denominated in
Table 5
Unconditional six-factor ICAPMa,b,c,d,e,f
Price of risk

Coefficient

t-statistic

Panel A: Parameter estimates

l0
lUS
lHK
lSI
lTA
lMA
lm

0.44
5.2687
5.0304
0.2043
0.1111
0.0949
0.0464

(5.6123)***
(7.8256)***
(7.4625)***
(1.6055)
(1.6110)
(2.4182)**
(1.5522)

Wald
69.2517

d.f.
6

P-value
0

68.8688

Panel B: Hypothesis tests

Null hypothesis
Are the prices of market and currency risk equal to
zero?
H0: lUS = lHK = lSI = lTA = lMA = lm =0
Are the prices of currency risk equal to zero?
H0: lUS = lHK = lSI = lTA = lMA = 0

E[rit Vt1] = 5l = 1ll cov[rit,r6+l,t Vt1]+lm cov[rit,rmt Vt1].

The GMM test is based on the moment condition in Eq. (29) with the instrumental variables reduced
to Z= 1.
c
The new term, l0 appears as a way of ensuring that Eq. (19) holds.
d
US, US dollar; HK, Hong Kong dollar; SI, Singapore dollar; TA, New Taiwan dollar; MA,
Malaysian Ringgit.
e
t-statistics are given in parentheses
f
Test of Overidentifying restrictions: J =8.0983 x 2 with 6 d.f. (critical value: x 2(0.05,6) =12.592).
*** Statistically significant at the 1% level.
** Statistically significant at the 5% level.
a

C.-S. Tai / J. of Multi. Fin. Manag. 9 (1999) 291316

309

the US dollar for developed countries. Panel B of Table 5 displays the unconditional test of ICAPM with five foreign exchange risk premia in addition to the
market risk premium. The J-test (x 26 = 8.09 with a P-value of 0.23) fails to
reject the model. The point estimate of the world price of market risk, which
approximates the constant relative risk aversion, is equal to 4.64 but its
robust t-statistic is not significant25. Since the goal of this study is to examine
the validity of risk premium hypothesis and the role of deviations from PPP
in the pricing of foreign exchange and equity markets, I test zero prices of
six risk factors considered in this paper (i.e. five exchange rate risks plus one market
risk). First, the joint null hypothesis of zero prices of foreign exchange risk and
market risk is significantly rejected with a P-value of zero based on the Wald test.
Second, the joint null hypothesis of zero prices of foreign exchange risk is also
significantly rejected with a P-value of zero. To provide further evidence of foreign
exchange risk pricing, I apply NeweyWest D-test (Newey and West, 1987) to
discriminate between the unconditional one-factor and six-factor ICAPMs since
they are nested. This test involves two steps. I first estimate the unconditional
six-factor ICAPM, which is the unrestricted model, and save the final weighting
matrix. I then use this weighting matrix to re-estimate the model under the
restriction of zero prices of foreign exchange risk, which is the null hypothesis. The
difference of the minimized objective functions from the two estimations is x 2
distributed with degrees of freedom equal to the number of restrictions that the
restricted model imposes on the unrestricted one. As can be seen from Table 7, the
null hypothesis of zero foreign exchange risk pricing is rejected with a P-value of
zero.
Based on above tests, one can conclude that the risk premium hypothesis is
supported, and the foreign exchange risk is priced in these five Asia
Pacific countries and the US In short, the unconditional tests indicate that
simply extending the domestic CAPM to an international setting is not
warranted and point out that researchers should consider other risk factors
such as the foreign exchange risk when testing international asset pricing
models.

5.2.2. Conditional tests of ICAPM

Tables 6 and 8 report the estimation results of the conditional ICAPMs. In Table
6, the conditional ICAPM with one-factor is rejected at 5% level by the J-test
(x 255 =221.8 with a P-value of zero) Table 7. However, the J-test fails to reject the
conditional six-factor ICAPM (x 230 = 28.96 with a P-value of 0.52) as shown in
Panel A of Table 8. The joint null hypothesis of zero prices on foreign exchange
aerisk and market risk is significantly rejected at 1% level based on the Wald test.
In addition, the joint null hypothesis of zero prices on foreign exchange risk is also
significantly rejected at 1% level. Moreover, the null hypothesis of constant prices
of foreign exchange risk is rejected with a P-value of 0.0006. These test results
25
The number reported in the table is equal to 0.0464 because we use percentage returns during the
estimation.

310

C.-S. Tai / J. of Multi. Fin. Manag. 9 (1999) 291316

Table 6
Conditional one-factor ICAPMa,b,c,d
Instruments (Z)

80

8m

CONSTANT

0.0037
(0.7887)
33.1423
(0.5648)
0.4318
(1.0171)
0.0513
(0.2251)
0.0048
(1.4015)

0.01557
(0.8182)
68.9460
(0.3710)
0.7800
(0.4658)
0.7045
(0.6825)
0.0101
(1.0504)

DEUROY
DIV
DUSTP
WORLD

E[rit Vt1] = lm, t1cov[rit, rmt Vt1] and l0, t1 =Zt180, lm, t1 =Zt18m.
The GMM test is based on the moment condition in Eq. (29) with the instrumental variables
including the lagged world excess equity return (WORLD), the S&P 500 dividend yield in excess of
7-day Euroyen deposit rate (DIV), the change in the US default premium (DUSTP), the change in 7-day
Euroyen deposit rate (DEUROY), and a CONSTANT. The new time varying term, l0, t1 appears as
a way of ensuring that Eq. (19) holds.
c
t-statistics are given in parentheses.
d
Test of overidentifying restrictions: J= 221.8724. x 2 with 55 d.f. (critical value: x 2(0.05, 55) =73.312).
a

simply that the foreign exchange risk is not only priced but also time-varying. To
find out which currency contributes to this time-varying foreign exchange risk
premia, I also conduct the Wald tests on the hypothesis of zero price on individual
currencies. As can be seen in the Panel B, the US dollar and the Hong Kong dollar
are the two major currencies that contribute to this time-varying characteristic of
foreign exchange risk premia.26 The instruments useful in predicting these timevarying risk prices are the DIV and DUSTP. To discriminate between these two
conditional ICAPMs, I again apply the NeweyWest D-test to test null hypothesis
of zero prices on foreign exchange risk. Table 7 shows that the D-statistics is
108.884 with a P-value of zero. Thus, the foreign exchange risk is priced in the
conditional ICAPM. Next I test the null hypothesis of time-invariant prices of
foreign exchange risk and it is also rejected by the D-test with a P-value of 0.0007.
These reinforce the test results based on the Wald tests that foreign exchange risk
is indeed time varying. Unlike Dumas and Solnik (1995) where they are able to
discriminate between the unconditional six-factor ICAPM and the conditional
counterpart based on the J-tests, I can not reject both models. To discriminate
between these two ICAPMs, I also conduct the D-test because they are nested.
Table 7 indicates that the null hypothesis of unconditional six-factor ICAPM is
26

As pointed out by the referee that Hong Kong dollar is pegged to the US dollar, so it is not
surprising to find similar behavior between these two currency returns. However, because the focus of
this paper is to see if the ICAPMs in the absence of PPP hold using Asia Pacific equity and currency
data, to incorporate the nature of different exchange rate arrangements into the model is beyond the
scope of this paper.

Table 7
Diagnosticsa,b,c

6.

ALTERNATIVE HYPOTHESIS (UNRESTRICTED MODEL)

x 2 DIFFERENCE (NEWEYWEST D D.F.

STATISTICS)

P-VALUE

Unconditional one-factor ICAPM

Unconditional one-factor ICAPM
Unconditional six-factor ICAPM
Conditional one-factor ICAPM
Time-invariant world price of market
risk
Time-invariant world prices of foreign
exchange risk

Unconditional six-factor ICAPM

Conditional six-factor ICAPM
Conditional six-factor ICAPM
Conditional six-factor ICAPM
Conditional six-factor ICAPM

76.96578.0983= 68.8674
145.153328.9636=116.19
79.858328.9636= 50.8947
137.848128.9636=108.884
32.261628.9636=3.2980

11
33
28
25
4

0
0
0.0051
0
0.5092

Conditional six-factor ICAPM

75.516228.9636= 46.5526

20

0.0007

a
NeweyWest D-test (Newey and West, 1987) involves two steps. We first estimate the unrestricted model, and save the final weighting matrix. We then
use this weighting matrix to re-estimate the model under the restriction, which is the null hypothesis. The difference of the minimized objective functions
from the two estimations is x 2 distributed with degrees of freedom equal to the number of restrictions that the restricted model imposes on the unrestricted
one.
b
One-factor, world market risk; six-factor, five foreign exchange risks plus world market risk; unconditional, prices of risk are time-invariant;
conditional, time-varying prices of risks.
c
NeweyWest D-statistics report on the x 2 for the difference of the minimized objective function from the estimations of both restricted and unrestricted
models.

C.-S. Tai / J. of Multi. Fin. Manag. 9 (1999) 291316

1.
2.
3.
4.
5.

NULL HYPOTHESIS (RESTRICTED

MODEL)

311

312

Table 8
Conditional six-factor ICAPMa,b,c,d,e
Instruments (Z)
Panel A: Parameter estimates
CONSTANT

DIV
DUSTP
WORLD
Panel B: Hypothesis tests
Null hypothesis
Are the prices of market and currency risk equal to zero?
H0: 8 kUS = 8 kHK =8 kSI =8 kTA =8 kMA =0
k= CONSTANT, DIV, DEUROY, DUSTP, WORLD
Are the prices of currency risk equal to zero?
H0: 8 kUS = 8 kHK =8 kSI =8 kTA =8 kMA =0
k= CONSTANT, DIV, DEUROY, DUSTP, WORLD
Are the prices of currency risk constant?
H0: 8 kUS = 8 kHK =8 kSI =8 kTA =8 kMA =0
k= DIV, DEUROY, DUSTP, WORLD
Is the price of the US dollar risk constant?
H0: 8 kUS = 0; k=DIV, DEUROY, DUSTP, WORLD
Is the price of the Hong Kong dollar risk constant?
H0: 8 kHK = 0; k =DIV, DEUROY, DUSTP, WORLD
Is the price of the Singapore dollar risk constant?
H0: 8 kSI = 0; k =DIV, DEUROY, DUSTP, WORLD
Is the price of the New Taiwan dollar risk constant?
H0: 8 kTA = 0; k=DIV, DEUROY, DUSTP, WORLD

8US

8HK

8SI

8TA

8MA

8m

0.52
(6.44)**
287.98
(0.37)
26.55
(2.84)**
16.20
(3.24)**
0.0002
(0.0045)

5.4485
(8.35)**
278.88
(0.04)
190.86
(2.86)**
111.07
(2.76)**
0.1580
(0.45)

5.2431
(7.84)**
3198.08
(0.42)
208.48
(3.16)**
115.87
(2.85)
0.1396
(0.37)

0.2434
(1.65)*
1913.24
(1.28)
11.67
(0.82)
0.3264
(0.03)
0.0041
(0.05)

0.0461
(0.51)
585.51
(0.28)
13.32
(1.85)*
0.9775
(0.20)
0.0474
(1.07)

0.1267
(1.86)*
178.86
(0.20)
4.6143
(0.93)
4.7962
(1.08)
0.0054
(0.21)

0.0440
(1.24)
363.13
(0.99)
7.3221
(0.62)
1.0769
(0.65)
0.0571
(0.48)

Wald

d.f.

P-value

110.55

30

108.88

25

46.55

20

0.0006

10.55

0.0321

12.82

0.0121

3.87

0.4235

7.25

0.1230

C.-S. Tai / J. of Multi. Fin. Manag. 9 (1999) 291316

DEUROY

Table 8
Conditional six-factor ICAPMa,b,c,d,e

Is the price of the Malaysian Ringgit risk constant?

H0: 8 kMA = 0; k =DIV, DEUROY, DUSTP, WORLD
Is the price of market risk constant?
H0: 8 km = 0; k = DIV, DEUROY, DUSTP, WORLD

Wald

d.f.

P-value

2.41

0.6615

3.29

0.5094

a
5

E[rit Vt1] = % ll,t1cov[rit,r6+l,t Vt1]+lm,t1cov[rit,rmt Vt1]

and l0, t1 =Zt180, ll, t1 = Zt18l, lm, t1 = Zt18m,

l= 1 5.

l=1

b
The GMM test is based on the moment condition in Eq. (29) with the instrumental variables including the lagged world excess equity return (WORLD),
the S&P 500 dividend yield in excess of 7-day Euroyen deposit rate (DIV), the change in the US default premium (DUSTP), the change in 7-day Euroyen
deposit rate (DEUROY), and a CONSTANT. The new time varying term, l0, t1, appears as a way of ensuring that Eq. (19) holds.
c
US, the US dollar; HK, Hong Kong dollar; SI, Singapore dollar; TA, New Taiwan dollar; MA, Malaysian Ringgit.
d
t-statistics are given in parentheses.
e
Test of overidentifying restrictions: J = 28.9636. x 2 with 30 d.f. (critical value: x 2(0.05, 30) = 43.773).
** Statistically significant at the 10% level.
* Statistically significant at the 5% level.

C.-S. Tai / J. of Multi. Fin. Manag. 9 (1999) 291316

Panel B: Hypothesis tests

Null hypothesis

313

314

C.-S. Tai / J. of Multi. Fin. Manag. 9 (1999) 291316

rejected with a P-value of 0.0051 implying that the conditional ICAPM in the
absence of PPP outperforms the unconditional counterpart.

6. Summary and conclusions

This paper examines the validity of the risk premia hypothesis in explaining
deviations from UIP and the role of deviations from PPP in the pricing of foreign
exchange rates and equity securities in five AsiaPacific countries and the US.
Using weekly data from 1 January, 1988 to 27 February, 1998, I find that
conditional variances are not related to deviations from UIP in any statistical sense
based on an univariate GARCH(1,1)-M model. As I consider both foreign exchange and equity markets together and test a conditional international CAPM in
the absence of PPP, I can not reject the model based on the J-test by Hansen
(1982), and find significant time-varying foreign exchange risk premia present in the
data.
Overall the findings in this paper support the idea that the predictable component
in deviations from UIP is due to a time-varying foreign exchange risk premium, and
not to irrationality among market participants. The evidence of significant foreign
exchange risk pricing supports the idea that foreign exchange risk is not diversifiable and hence investors should be compensated for bearing this risk. It also
supports the role of deviations from PPP in pricing foreign exchange rates and
equity securities since foreign exchange risks are modeled as covariances between
excess returns and deviations from PPP in this paper. Furthermore, the empirical
results found in this paper suggest that a multi-factor asset pricing model outperforms a single-factor asset pricing model, and especially in its conditional form.

Acknowledgements
This paper is part of my doctoral thesis at the Ohio State University. I wish to
thank my advisor, Nelson C. Mark, for his guidance, and Paul Evans, Zhiwu Chen,
J. Huston McCulloch and seminar participants at the 1999 EFA Annual Meeting in
Miami Beach, FL, the 5th TCFA Annual Meeting in Boston, MS, the 7th SFM
Conference in Kaohsiung, Taiwan, ROC, and the 11th AFBC in Sydney, Australia
for their helpful comments and suggestions.

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