Does the Consumption CAPM Help in Accounting for Expected Currency Returns?

The Consumption Capital Asset Pricing Model (CCAPM) has been widely rejected on the basis of its implausibly large estimates of risk aversion, despite numerous modifications to its specification of risk preferences. This study instead relaxes the assumption of perfect foresight (REH), and uses survey data on traders' exchange rate forecasts to test whether the expected premium is related to the covariance between the exchange rate and consumption. The covariance is measured through the novel use of rolling-windows of the realized covariance. Interestingly, the model is able to account for expected returns with more plausible degrees of risk aversion, but only once using backward-looking rolling measures of the covariance, suggesting market participants infer about the future covariance based on experience from the recent past. There is also evidence that inclusion of the real exchange rate improves the plausibility of the estimates and the model fit.