Modeling the Currency Forward Risk Premium: Theory and Evidence

Ram Bhar, Carl Chiarella and Toan Pham
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Ram Bhar: School of Banking and Finance, University of New South Wales
Toan Pham: School of Banking and Finance, University of New South Wales

No 41, Research Paper Series from Quantitative Finance Research Centre, University of Technology, Sydney

Abstract: 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.

Pages: 34 pages
Date: 2000-04-01
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Citations: View citations in EconPapers (3)

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