Review of Quantitative Finance and Accounting, 24: 295–312, 2005
2005 Springer Science + Business Media, Inc. Manufactured in The Netherlands.
International Asset Excess Returns and Multivariate
THOMAS C. CHIANG
Department of Finance, Drexel University, 3141 Chestnut Street, Philadelphia, PA 19104, USA, Tel.: 215-8951745;
Department of Finance, National Chung Hsing University, 250 Kuo Kuang Road, Taichung 402, Taiwan ROC,
Tel.: 886-4-22850940; Fax: 886-4-22856015
Abstract. This paper constructs a multivariate model in relating multi-asset excess returns to their conditional
variances. Applying weekly data to investigate the foreign-exchange risk premium, the evidence from a multi-
variate GARCH model shows that the foreign-exchange excess returns are signiﬁcantly correlated with economic
fundamentals such as the real interest-rate differential, long-short interest-rate spread differential, and equity-
premium differential. The evidence also suggests that foreign-exchange excess returns are not independent of the
conditional variances of these fundamental variables, supporting the time-varying risk-premium hypothesis.
Keywords: exchange rate risk, time-varying risk premiums, international asset pricing, multivariate GARCH
JEL Classiﬁcation: C22, F31, G12, G15
By deﬁnition, an exchange rate is the price of one currency in terms of another and a
forward rate is the contractual exchange rate established at date t for a transaction that
will occur at date t + k in the future (the maturity date). Assuming that the forward-
exchange market is efﬁcient and speculators are rational, risk-neutral investors ensure that
the forward rate is an unbiased predictor of the expected future spot rate. However, the
unbiasedness hypothesis has been rejected by many empirical studies based on various
theoretical arguments, econometric techniques, and data sets (e.g., Hansen and Hodrick,
1980; Fama, 1984; Korajczyk, 1985; Hodrick, 1987; Chiang, 1988; Barnhart and Szakmary,
1991; Goodhart, McMahon, and Ngama, 1997).
Attempts in literature to explain risk premiums in the foreign-exchange market have
taken several forms.
The ﬁrst approach is the portfolio-balance model that seeks to ex-
plain the risk premium in a mean-variance optimization framework. In this model the
risk premium depends in a speciﬁc way on the supplies of assets denominated in vari-
ous currencies, the variance-covariance matrix of the rates of returns, and the coefﬁcient