Premia in Forward Foreign Exchange as Unobserved Components: A Note |
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| Authors: | Theo E Nijman Franz C Palm Christian CP Wolff |
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| Institution: | 1. Department of Econometrics , Tilburg University , 5000 , LE , Tilburg , The Netherlands;2. Faculty of Economics and Business Administration , University of Limburg , 6200 , MD , Maastricht , The Netherlands |
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| Abstract: | We reconsider the signal-extraction approach to measuring premia in the pricing of forward foreign exchange, put forward by Wolff, in which the difference between the forward rate and the associated future spot rate is modeled as an autoregressive moving average (ARMA) model for the risk premium buried in a white-noise forecast error. We point out that an ARMA model for the risk premium is not always identifiable from information on the difference between the forward rate and the future spot rate only. We present solutions to the problem of identification and show how the model for the risk premium can be estimated in a direct way, provided that the identification problem is solved. For reason of comparison, we use the series analyzed by Wolff to estimate the models for risk premia. The results confirm the earlier finding that premia in forward exchange exhibit a certain degree of persistence over time. |
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| Keywords: | ARMA models Exchange risk Identification Kalman filter |
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