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Analysis of Time Varying Exchange Rate Risk Premia

Chapter
Part of the Studies in Computational Finance book series (SICF, volume 1)

Abstract

There is a huge literature on the existence of risk premia in the foreign exchange market 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 spotforward price relationship and assuming a geometric diffusion 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 Kaiman filtering techniques. The approach we adopt allows us to use daily observations of forward exchange rates of different maturities. This, in turn, characterises the risk premium over time for different time to maturities, thus obtaining a term structure for the risk premium. We present the results of application of our methodology to the Australian dollar and the British pound, both against the U.S. dollar, for three different maturities of forward exchange rates.

Key words

Arbitrage forward exchange premium market price of risk filtering. 

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Copyright information

© Springer Science+Business Media New York 2000

Authors and Affiliations

  1. 1.School of Finance & EconomicsUniversity of TechnologySydneyAustralia
  2. 2.University of TechnologySydneyAustralia

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