Modeling the Currency Forward Risk Premium: Theory and Evidence
There is a huge literature on the existence of risk premia in the foreign exchange markets and its influence in explaining the divergence between the forward exchange rate and the subsequently realised spot exchange rate. In this paper, we seek to model directly the risk premium as a mean-reverting diffusion process. This is done by making use of the spot-forward price relationship and assuming a geometric Brownian process for the spot exchange rate. We are able to obtain a stochastic differential equation system for the spot exchange rate, the forward exchange rate and the risk premium which we estimate using Kalman filtering techniques. The model is then applied to the French Franc/USD and Japanese Yen/USD exchange rates from 1 January 1990 to 31 December 1998. For both currencies our main findings show (I) the persistence of substantial positive time variation in the forward risk premium and its alternating regimes; and (ii) the presence of a term structure of the forward risk premia.
|Date of creation:||01 Apr 2000|
|Date of revision:|
|Contact details of provider:|| Postal: PO Box 123, Broadway, NSW 2007, Australia|
Phone: +61 2 9514 7777
Fax: +61 2 9514 7711
Web page: http://www.qfrc.uts.edu.au/
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Ramaprasad Bhar & Carl Chiarella, 1997.
"Interest rate futures: estimation of volatility parameters in an arbitrage-free framework,"
Applied Mathematical Finance,
Taylor & Francis Journals, vol. 4(4), pages 181-199.
- Ram Bhar & Carl Chiarella, 1995. "Interest Rate Futures: Estimation of Volatility Parameters in an Arbitrage-Free Framework," Working Paper Series 55, Finance Discipline Group, UTS Business School, University of Technology, Sydney.
- Bekaert, Geert, 1994. "Exchange rate volatility and deviations from unbiasedness in a cash-in-advance model," Journal of International Economics, Elsevier, vol. 36(1-2), pages 29-52, February.
- Canova, Fabio, 1991. "An Empirical Analysis of Ex Ante Profits from Forward Speculation in Foreign Exchange Markets," The Review of Economics and Statistics, MIT Press, vol. 73(3), pages 489-96, August.
- Lucas, Robert Jr., 1982. "Interest rates and currency prices in a two-country world," Journal of Monetary Economics, Elsevier, vol. 10(3), pages 335-359.
- Baillie, Richard T. & Bollerslev, Tim, 1990. "A multivariate generalized ARCH approach to modeling risk premia in forward foreign exchange rate markets," Journal of International Money and Finance, Elsevier, vol. 9(3), pages 309-324, September.
- Harvey,Andrew C., 1990.
"Forecasting, Structural Time Series Models and the Kalman Filter,"
Cambridge University Press, number 9780521321969, November.
- Harvey,Andrew C., 1991. "Forecasting, Structural Time Series Models and the Kalman Filter," Cambridge Books, Cambridge University Press, number 9780521405737, November.
- Nijman, Theo E & Palm, Franz C & Wolff, Christian C P, 1993. "Premia in Forward Foreign Exchange as Unobserved Components: A Note," Journal of Business & Economic Statistics, American Statistical Association, vol. 11(3), pages 361-65, July.
- John H. Cochrane, 1999.
"New Facts in Finance,"
CRSP working papers
490, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
- Ostdiek, Barbara, 1998. "The world ex ante risk premium: an empirical investigation," Journal of International Money and Finance, Elsevier, vol. 17(6), pages 967-999, December.
- Canova, Fabio & Ito, Takatoshi, 1991. "The Time-Series Properties of the Risk Premium in the Yen/Dollar Exchange Market," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 6(2), pages 125-42, April-Jun.
- Charles Engel, 1995.
"The Forward Discount Anomaly and the Risk Premium: A Survey of Recent Evidence,"
NBER Working Papers
5312, National Bureau of Economic Research, Inc.
- Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, vol. 3(2), pages 123-192, June.
- Wolff, Christian C P, 1987.
" Forward Foreign Exchange Rates, Expected Spot Rates, and Premia: A Signal-Extraction Approach,"
Journal of Finance,
American Finance Association, vol. 42(2), pages 395-406, June.
- Wolff, Christian C, 1987. "Forward Foreign Exchange Rates, Expected Spot Rates, and Premia: A Signal-Extraction Approach," CEPR Discussion Papers 189, C.E.P.R. Discussion Papers.
- Andrew Harvey & Esther Ruiz & Neil Shephard, 1994. "Multivariate Stochastic Variance Models," Review of Economic Studies, Oxford University Press, vol. 61(2), pages 247-264.
- Canova, Fabio & Marrinan, Jane, 1993. "Profits, risk, and uncertainty in foreign exchange markets," Journal of Monetary Economics, Elsevier, vol. 32(2), pages 259-286, November.
- Rene M. Stulz, 1994. "International Portfolio Choice and Asset Pricing: An Integrative Survey," NBER Working Papers 4645, National Bureau of Economic Research, Inc.
- Boudoukh, Jacob & Richardson, Matthew & Smith, Tom, 1993. "Is the ex ante risk premium always positive? *1: A new approach to testing conditional asset pricing models," Journal of Financial Economics, Elsevier, vol. 34(3), pages 387-408, December.
- Bakshi, Gurdip S & Naka, Atsuyuki, 1997. "Unbiasedness of the Forward Exchange Rates," The Financial Review, Eastern Finance Association, vol. 32(1), pages 145-62, February.
- Yangru Wu & Hua Zhang, 1997. "Forward premiums as unbiased predictors of future currency depreciation: a non-parametric analysis," Journal of International Money and Finance, Elsevier, vol. 16(4), pages 609-623, August.
- Wolff, Christian C. P., 2000. "Measuring the forward foreign exchange risk premium: multi-country evidence from unobserved components models," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 10(1), pages 1-8, January.
When requesting a correction, please mention this item's handle: RePEc:uts:rpaper:41. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Duncan Ford)
If references are entirely missing, you can add them using this form.