Title: Inference on forward exchange rate risk premium: reviewing signal extraction methods

Authors: Ramaprasad Bhar, Carl Chiarella

Addresses: School of Banking and Finance, The Australian School of Business, The University of New South Wales, 2052 Sydney, Australia. ' School of Finance and Economics, University of Technology, Sydney, P.O. Box 123, Broadway, NSW 2007, Australia

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.

Keywords: forward exchange rates; risk premium; signal extraction; market price of risk; future spot exchange rates; random walk forecast.

DOI: 10.1504/IJMEF.2009.024835

International Journal of Monetary Economics and Finance, 2009 Vol.2 No.2, pp.115 - 125

Published online: 01 May 2009 *

Full-text access for editors Full-text access for subscribers Purchase this article Comment on this article