This paper is to analyze characteristics of the foreign exchange market in four major East Asian countries (Korea, Thailand, Singapore and Japan) before and after the financial crisis and to get implications of it. Our focus is given on the relationship between exchange rate volatilities and risk premium on the selected countries. The crisis-hit countries in the region including Korean and Thailand show structural break during the Asian crisis in representing higher standard deviations on nominal exchange rates since 1997. However, it is argued that they returned to the previous rigid exchange movements due to a fear of floating. Nevertheless, it is believed that the exchange rate arrangements in crisis-hit countries differ from the previous psedo-dollar pegged system.
To examine the market structure in foreign exchange trading, we take a foreign exchange risk premium in the selected countries. Risk premium is defined as the difference between expected spot exchange rate of market participants and forward rate. Expected spot exchange rate of market participants is inferred by using time series methodology. Risk premium is selected as a standard of actual analysis to compare characteristics of foreign exchange market. The reason of using foreign exchange rate risk premium is because changes in risk premium have been focused in previous works that analyzed changes of foreign exchange system and foreign exchange market.
We present the theoretical model for foreign exchange risk premium in a Lucas type model in order to explore the characteristics of the risk premium. Lucas' model is a dynamic optimizing model of asset pricing that includes an important aspect of money into the model specification.
Empirical analysis of the time-varying risk premium is also provided. To summarize the result of the empirical estimation is following: First, risk premium of won/dollar exchange rate is analyzed to have negative value regardless of period or country. Risk premium of Singapore Dollar on US Dollar has positive value mostly in analysis period. The result of analyzing Thailand is statistically unstable and to use simple VAR for presumption of risk premium is not desirable in case of Thailand.
Second, absolute value of won/dollar exchange rate risk premium decreased after the crisis. Considering that volatility of exchange rate and risk premium has close relationship, it is interesting that risk premium decreased even though volatility of won/dollar exchange rate increased about twice. After all, market risk for won/dollar exchange rate seems to be reduced in Period II, just after the crisis. On the other hand, risk of yen/dollar exchange rate did not change much, but risk premium per unit currency risk is assumed to increase.
Third, correlation of risk premium among countries became stronger after the crisis. The degree of co-movement in risk premium of won/dollar, Singapore dollar/U.S. dollar and yen/dollar increased more than seven times and two times respectively. It is analyzed that increase of correlation on risk premium is resulted from increased co-movement of interest rates. In addition, the increasing volatilities in the selected countries are resulted from the increased covariance between risk premium and forward premium.
According to this analysis, it concluded that increase of exchange rate fluctuation could not be increase of risk in foreign exchange market. In addition, efficiency of foreign exchange market seems to increase in most countries. If the price of exchange rate is determined efficiently due to changes of exchange rate regimes and liberalization of foreign exchange transactions, and reduction of uncertainness caused by governmental interruption, it can be a reasonable consequence. In brief, it can be a positive effect of liberalization of foreign exchange transactions in East Asia. Besides, it is not proper to judge negative effect of liberalization of foreign exchange market and adoption of free floating exchange regime only with increased volatility of fluctuation of exchange rates.

Executive Summary

I. Introduction

II. Literature Review

III. Theoretical Model for the Time-Varying Risk Premium

IV. Empirical Analysis

V. Conclusion

References