Risk Premia in Forward Foreign Exchange Markets : A Comparison of Signal Extraction and Regression Methods

We investigate possible presence of time-varying risk premia in forward pound, yen,and Euro monthly exchange rates versus the US dollar 3 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