Premia in Forward Foreign Exchange as Unobserved Components: A Note

Theo E. Nijman · Franz C. Palm · Christian C. P. Wolff

26 citations0/0 files storedJournal of Business and Economic Statistics

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Monetary Policy and Economic Impact Financial Markets and Investment Strategies Financial Risk and Volatility Modeling

Abstract

We reconsider the signal-extraction approach to measuring premia in the pricing of forward foreign exchange, put forward by Wolff, in which the difference between the forward rate and the associated future spot rate is modeled as an autoregressive moving average (ARMA) model for the risk premium buried in a white-noise forecast error. We point out that an ARMA model for the risk premium is not always identifiable from information on the difference between the forward rate and the future spot rate only. We present solutions to the problem of identification and show how the model for the risk premium can be estimated in a direct way, provided that the identification problem is solved. For reason of comparison, we use the series analyzed by Wolff to estimate the models for risk premia. The results confirm the earlier finding that premia in forward exchange exhibit a certain degree of persistence over time.

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References

1983Empirical exchange rate models of the seventies 1984Forward and spot exchange rates 1980Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis 1982Interest rates and currency prices in a two-country world 1993Temporal Aggregation of Garch Processes 1985Conditional variance and the risk premium in the foreign exchange market 1984Exchange rates and international macroeconomics 1988The econometric analysis of models with risk terms

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