Estimation and simulation of risk premia in equity and foreign exchange markets

There is substantial evidence to reject constant-risk-premia financial models. While time-varying risk premia are often mentioned as an alternative, the literature has yet to produce an example that accounts for the important time-series properties of asset returns. We inquire whether mean-variance optimization models can do so. We model asset risk with an absolute-error version of the ARCH-in-mean hypothesis and model hedging motives that derive from variation in future real income and inflation to account for agent heterogeneity. We consider a three-country-and-two-asset world. Our model predicts values for five excess returns relative to the US bill rate. We use a systems approach to estimate the model parameters and then simulate the estimated model to determine if it can account for the important time-series properties of risk premia. (C) 2000 Elsevier Science Ltd, All rights reserved.