Inference on forward exchange rate risk premium: reviewing signal extraction methods. (5th May 2009)

• Record Type: Journal Article
• Authors: Bhar, Ramaprasad; Chiarella, Carl
• Is Part Of: International journal of monetary economics and finance. Volume 2:Number 2(2009)
• Page Start: 115
• Page End: 125
• Publication Date: 2009-05-05
• Subjects: forward exchange rates -- risk premium -- signal extraction -- market price of risk -- future spot exchange rates -- random walk forecast; Monetary policy -- Periodicals; Finance -- Periodicals; Economics -- Mathematical models -- Periodicals; 332.4
• Languages: English
• ISSNs: 1752-0479

Abstract

The existence of risk premium is thought to be the reason why forward exchange rate is not an unbiased predictor of future spot exchange rate. In this paper we review two methodologies for inferring this unobserved risk premium based upon signal extraction mechanism. One approach relies on the theory of derivatives pricing that relates historical and risk neutral measures via market price of risk. The other approach specifies the risk premium in the historical measure directly. We compare these two methods in predicting future spot exchange rates and contrast these with that of random walk forecast.