Asset price based estimates of sterling exchange rate risk premia

In this paper we report estimates of the risk premium for the pound sterling exchange rates vis-à-vis the Australian dollar, the Canadian dollar, a synthetic Euro, the Japanese yen and the US dollar over a monthly 1987–2001 sample, generated using a conditional factor model for the stochastic discount factor of a representative ‘worldwide’ investor. The model relates this stochastic discount factor to the real return on a ‘worldwide’ stock portfolio as well as the growth rate in ‘worldwide’ industrial production, with the model parameters varying with variations in both the slope of the ‘world’ term structure of interest rates and the price/earnings ratio that corresponds with the ‘worldwide’ stock portfolio. Econometric tests indicate that this model is accepted by the data. The corresponding parameter estimates are used to compute the risk premium for the five aforementioned sterling exchange rates. Although the estimated risk premia exhibit realistic time series dynamics, we show that only in the case of the sterling/yen exchange it can explain the observed deviations from uncovered interest rate parity over our sample period.