Modelling the currency forward risk premium: A new perspective
- Publication Type:
- Journal Article
- Asia-Pacific Financial Markets, 2001, 8 (4), pp. 341 - 360
- Issue Date:
Copyright Clearance Process
- Recently Added
- In Progress
- Closed Access
This item is closed access and not available.
In this paper we seek to develop a new approach to the time series analysis of foreign exchange risk premia. We do so by assuming a geometric Brownian process for the spot exchange rate and expressing the no-arbitrage spot-forward price relationship under the historical probability measure. We are thereby able to obtain a stochastic differential equation system linking the spot exchange rate, the forward exchange rate and the risk premium (modelled directly as a mean-reverting diffusion process) which we estimate using Kalman filtering techniques. We are able to use observations at a range of frequencies since the framework we set up does not involve overlapping observations. The model is then applied to the French Franc/USD, DEM/USD, GBP/USD, and Japanese Yen/USD exchange rates from 1 January 1990 to 31 December 1998. For all currencies we find evidence that the forward risk premium is stationary and exhibits substantial positive time variation. © 2002 Kluwer Academic Publishers.
Please use this identifier to cite or link to this item: