Macroeconomic Sources of Foreign Exchange Risk

Abstract

We address the issue of foreign exchange risk and its macroeconomic determinants in several new EU members. The joint distribution of excess returns in the foreign exchange market and the observable macroeconomic factors is modeled using the stochastic discount factor (SDF) approach and a multivariate GARCH-in-mean model. We find that in post-transition economies real factors play a small role in determining foreign exchange risk, while nominal and monetary factors have a significant impact. Therefore, to contribute to the further stability of their domestic currencies, the central banks in the new EU member countries should continue stabilization policies aimed at achieving nominal convergence with the core EU members, as nominal factors play a crucial role in explaining the variability of the risk premium.