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176CHAPTER 6. FOREIGN EXCHANGE MARKET EFFICIENCYThe Nominal Risk Premium.Multiply (6.11) by P t and divide through by S t to get"Ã ! µFt P t − S # t+1E t µ t+1 =0.P t+1 S tLetµ m t+1 = µ P tt+1 . (6.15)P t+1Since 1 P tis the purchasing power of one domestic currency unit andu 0 (C t)P tis the marginal utility of money, we will call µ m t+1 the intertemporalmarginal rate of substitution of money. In chapter 4, (equation(4.62)) we found that the price of a one-period riskless domestic currencynominal bond is (1 + i t ) −1 =E t (µ m t+1).Using (6.12), set Y t+1 = (Ft−S t+1)P t+1and X t+1 = µ m t+1. Because F tS tisknown at date t, it can be treated as a constant and you get¸··Ft − S t+1E t =(1+i t )Cov tS tµ m t+1 , S t+1S t¸. (6.16)Perhaps now you can see more clearly why the foreign currency (euro)is risky h when i the forward euro contract offersanexpectedproÞt. IfE Ft−S t+1t P t+1< 0, the covariance in (6.16) must be negative. In the badstate, µ m t+1 is high because consumption growth is low. This is associatedwith a weakening of the euro (low values of S t+1S t). The euro is riskybecause its value is positively correlated with consumption. Agents consumeboth the domestic and the foreign goods but the foreign currencybuysfewerforeigngoodsinthebadstateofnatureandisthereforeabad hedge against low consumption states.Pitfalls in pricing nominal contracts. Suppose that individuals are riskneutral. Then µ m t+1 = βP tP t+1and the covariance in (6.16) need not be0 and again you can see that the forward rate is not necessarily therationally expected future spot rate. Agents care about real proÞts,not nominal proÞts. Under risk neutrality, equilibrium expected realproÞts are 0, but in order to achieve zero expected real proÞts, theforward rate may have to be a biased predictor of the future spot.