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Time-varying/Sign-switching Risk Perception on Foreign Exchange Markets

In this paper we analyse the consequences of considering risk-augmented specifications of the relationship between spot and forward rates. Previous parametric specifications such as the GARCH-M provided disappointing results possibly due to the high degree of persistence of the estimated process for conditional volatility. We propose a more flexible semiparametric approach where a nonparametric estimator of the conditional volatility is used as an instrumental variable, and we apply it on six major currencies vis-a-vis the Deutsche Mark (monthly data). An interesting picture of shifting risk perception arises when an indicator of market sentiment in the form of trading signals to purchase or sell a currency is inserted in the model. Copyright @ 1998 by John Wiley & Sons, Ltd. All rights reserved.