THE TIME-VARIATION OF EXPECTED RETURNS AND VOLATILITY IN FOREIGN-EXCHANGE MARKETS

This article analyzes the time variation in conditional means and variances of monthly and quarterly excess dollar returns on Eurocurrency investments. All results are based on a vector autoregression with weekly sampled data on exchange-rate changes and forward premiums of three currencies. Both past exchange-rate changes and forward premiums predict future forward-market returns. Moreover, past forward-premium volatilities predict the volatility of exchange rates. Expected forward-market returns are very variable and persistent and exhibit marked comovements. These results carry over to cross-rate (e.g., yen/mark) investments as well.