PREMIA IN FORWARD FOREIGN-EXCHANGE AS UNOBSERVED COMPONENTS

We reconsider the signal-extraction approach to measuring premia in th e 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 fro m information on the difference between the forward rate and the futur e spot rate only. We present solutions to the problem of identificatio n and show how the model for the risk premium can be estimated in a di rect way, provided that the identification problem is solved. For reas on of comparison, we use the series analyzed by Wolff to estimate the models for risk premia. The results confirm the earlier finding that p remia in forward exchange exhibit a certain degree of persistence over time.