Inference on forward exchange rate risk premium: reviewing signal extraction methods
- Publication Type:
- Journal Article
- International Journal of Monetary Economics and Finance, 2009, 2 (2), pp. 115 - 125
- Issue Date:
The existence of risk premium is thought to be the reason why forward exchange rate is not an unbiased predictor of future spot exchange rate. In this paper we review two methodologies for inferring this unobserved risk premium based upon signal extraction mechanism. One approach relies on the theory of derivatives pricing that relates historical and risk neutral measures via market price of risk. The other approach specifies the risk premium in the historical measure directly. We compare these two methods in predicting future spot exchange rates and contrast these with that of random walk forecast. © 2009 Inderscience Enterprises Ltd.
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