Time-varying risk premia in the foreign currency futures basis

Abstract

Significant time-varying risk premia exist in the foreign currency futures basis, and these risk premia are meaningfully correlated with common macroeconomic risk factors from equity and bond markets. The stock index dividend yield and the bond default and term spreads in the U.S. markets help forecast the risk premium component of the foreign currency futures basis. The specific source of risk matters, but the relationships are robust across currencies. The currency futures basis is positively associated with the dividend yield and negatively associated with the spread variables. These correlations cannot be attributed to the expected spot price change component of the currency futures basis, thus establishing the presence of a timevarying The presence of a time-varying risk premium (TVRP) was confirmed in a variety of futures markets for commodities by Bailey and Chan (1993), who found that a small number of macroeconomic

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