Estimation of Exchange Rate Risk Premium using State-Space Method

In this paper, we estimate risk premium in won-dollar foreign exchange market. Different from previous studies, we use a state-space model and it is estimated by Kalmanfilter approach. From a state-space model, we extract unobserved risk premium component. Estimated risk premium series show a substantial degree of persistence and become volatile when the uncertainty in market increases. To examine the relationship between the foreign exchange risk premium and macroeconomic variables, the estimated series is regressed on some macroeconomic variables such as money supply, industrial production and interest rates. We find that the risk premium responds to the changes in domestic money supply and output level. The risk premium also moves positively with the changes in stock market volatility.