Risk premia in forward foreign exchange rates: a comparison of signal extraction and regression methods

We investigate possible presence of time-varying risk premia in forward pound, yen, and Euro monthly exchange rates versus the US dollar over the last two decades. We study this issue using regression techniques and separately using a signal plus noise model. Our models account for time-varying vola...

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Bibliographic Details
Published in:Empirical economics 2012-02, Vol.42 (1), p.21-51
Main Authors: Wang, Zhiguang, Bidarkota, Prasad V.
Format: Article
Language:English
Subjects:
American dollar
Currencies
Econometrics
Economic Theory/Quantitative Economics/Mathematical Methods
Economics
Economics and Finance
Finance
Foreign exchange markets
Foreign exchange rates
Forward exchange
Insurance
Management
Noise
Random variables
Risk premiums
Statistics for Business
Time series
Volatility
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Summary:We investigate possible presence of time-varying risk premia in forward pound, yen, and Euro monthly exchange rates versus the US dollar over the last two decades. We study this issue using regression techniques and separately using a signal plus noise model. Our models account for time-varying volatility and non-normality in the observed series. Our regression model rejects the hypothesis that the forward rate is an unbiased predictor of future spot exchange rate, indicating the existence of time-varying risk premium under rational expectations. Our signal plus noise model reveals a time-varying risk premium component in yen and Euro. The same model provides evidence for the presence of risk premium in pound over a shorter sample period, though not over the entire sample. We conclude that risk premia exist, although we may fail to detect these for some currencies over specific time periods.
ISSN:0377-7332
1435-8921
DOI:10.1007/s00181-010-0427-y