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

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Abstract

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.

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Authors and Affiliations

  1. Department of Economics, South Dakota State University, SSB 118, Box 504, 57007, Brookings, SD, USA

    Zhiguang Wang

  2. Department of Economics, Florida International University, University Park DM 320A, Miami, FL, 33199, USA

    Prasad V. Bidarkota

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  1. Zhiguang Wang
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  2. Prasad V. Bidarkota
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Correspondence to Zhiguang Wang.

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An earlier version of this paper authored by Prasad V. Bidarkota was circulated as, “Risk Premia in Forward Foreign Exchange Markets: A Comparison of Signal Extraction and Regression Methods”.

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Wang, Z., Bidarkota, P.V. Risk premia in forward foreign exchange rates: a comparison of signal extraction and regression methods. Empir Econ 42, 21–51 (2012). https://doi.org/10.1007/s00181-010-0427-y

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  • DOI: https://doi.org/10.1007/s00181-010-0427-y

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