Forward Foreign Exchange Rates, Expected Spot Rates, and Premia: A Signal-Extraction Approach



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    • London Business School. This paper builds on Chapter 6 of the author's doctoral dissertation at the Graduate School of Business, University of Chicago. He is very grateful to the members of his dissertation committee—Michael Mussa (Chairman), Joshua Aizenman, Robert Aliber, Jacob Frenkel, David Hsieh, John Huizinga, and Arnold Zellner—and to Michael Adler, Robert Cumby, Julian Franks, Andrew Harvey and an anonymous referee of this Journal for valuable suggestions and discussions. Helpful comments from seminar participants at the University of Chicago, the London Business School, INSEAD, the London School of Economics, the 1986 Western Finance Association Meetings in Colorado Springs, the 1986 North American Summer Meetings of the Econometric Society at Duke University, and the 1986 European Finance Association Meetings in Dublin are also gratefully acknowledged. Any remaining errors are the responsibility of the author.


In this paper, we implement a methodology to identify and measure premia in the pricing of forward foreign exchange that involves application of signal-extraction techniques from the engineering literature. Diagnostic tests indicate that these methods are quite successful in capturing the essence of the time-series properties of premium terms. The estimated premium models indicate that premia show a certain degree of persistance over time and that more than half the variance in the forecast error that results from the use of current forward rates as predictors of future spot rates is accounted for by variation in premium terms. The methodology can be applied straightforwardly to the measurement of unobservables in other financial markets.