Rationality and the Risk Premium on the Australian dollar

A Model of the forward rate error of the USD/AUD spot exchange rate is fitted to daily data for the period 15th December 1983 to 31st December 1991. This provides a data set of 2034 daily trading observations. Explanations of the forecast error include a risk premium represented by a constant plus the conditional variance generated from a GARCH (1,1)-M analysis of the error process and information variables in the form of lagged forward rate errors. The following conclusions are drawn form estimates for the full sample: the USD/AUD spot rate is subject to a constant premium: there is little evidence to support a time varying component and the market is influenced by lagged forward errors. Sub period estimation confirms these results, although a time varying premium is evident prior to the February 1985 depreciation. The economic implications of these findings are discussed. [F31]. © 1997, Taylor & Francis Group, LLC.