Modelling the currency forward risk premium: A new perspective

Springer Netherlands
Publication Type:
Journal Article
Asia Pacific Financial Markets, 2001, 8 (4), pp. 341 - 360
Issue Date:
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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
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