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Modelling the Currency Forward Risk Premium: A New Perspective
Authors:Ramaprasad Bhar  Carl Chiarella  Toan M. Pham
Affiliation:(1) School of Banking and Finance, The University of New South Wales, Sydney, 2052, Australia;(2) School of Finance and Economics, University of Technology, Sydney, PO Box 123, Broadway, NSW, 2007, Australia;(3) School of Banking and Finance, The University of New South Wales, Sydney, 2052, Australia
Abstract:In this paper we seek to develop a new approach to the time series analysis of foreign exchange risk premia. We do so by assuming a geometric Brownian process for the spot exchange rate and expressing the no-arbitrage spot-forward price relationship under the historical probability measure. We are thereby able to obtain a stochastic differential equation system linking the spot exchange rate, the forward exchange rate and the risk premium (modelled directly as a mean-reverting diffusion process) which we estimate using Kalman filtering techniques. We are able to use observations at a range of frequencies since the framework we set up does not involve overlapping observations. The model is then applied to the French Franc/USD, DEM/USD, GBP/USD, and Japanese Yen/USD exchange rates from 1 January 1990 to 31 December 1998. For all currencies we find evidence that the forward risk premium is stationary and exhibits substantial positive time variation.
Keywords:arbitrage  filtering  forward premium  market price of risk
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