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Arbitrage-free affine models of the forward price of foreign currency

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  • J. Benson Durham

Abstract

Forward foreign exchange contracts embed not only expected depreciation but also a sizable premium, which complicates inferences about anticipated returns. This study derives arbitrage-free affine forward currency models (AFCMs) with closed-form expressions for both unobservable variables. Model calibration to forward term structures of eleven U.S.-dollar currency pairs from the mid-to-late 1990s through early 2014 fits the data closely and suggests that the premium is indeed nonzero and variable, but not to the degree implied by previous econometric studies.

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  • J. Benson Durham, 2014. "Arbitrage-free affine models of the forward price of foreign currency," Staff Reports 665, Federal Reserve Bank of New York.
    • Handle: RePEc:fip:fednsr:665
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    References listed on IDEAS

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    More about this item

    Keywords

    arbitrage-free model; foreign exchange;

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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