Tests of the risk premium on foreign currency futures impiled by the intertemporal asset pricing theory

Abstract

In earlier literature on futures exchange rates, some evidence against the martingale hypothesis is not accompanied by an explicit alternative hypothesis derived from the asset pricing theory. This paper utilizes the asset pricing theory to show that the rate of growth of futures price is a function of the rate of growth of the per capita consumption, the logarithm of the gross risk-free rate of return and the time varying risk premium. The form of risk premium implied by the asset pricing theory is examined and its statistical significance is tested with the British Pound and German Deutschemark futures. Consequently, the specification of the test equation implied by the asset pricing theory is tested against ad hoc test equations of the martingale hypothesis. For both currency futures, there is strong evidence against the ad hoc test equations of the martingale hypothesis.