Arbitrage-Free Affine Models of the Forward Price of Foreign Currency
29 Pages Posted: 3 Mar 2014
Date Written: February 1, 2014
Forward foreign exchange contracts embed not only expected depreciation but also a sizable premium, which complicates inferences about anticipated returns. This study derives arbitrage-free affine forward currency models (AFCMs) with closed-form expressions for both unobservable variables. Model calibration to forward term structures of eleven U.S.-dollar currency pairs from the mid-to-late 1990s through early 2014 fits the data closely and suggests that the premium is indeed nonzero and variable, but not to the degree implied by previous econometric studies.
Keywords: arbitrage-free model, foreign exchange
JEL Classification: G10, G12, G15
Suggested Citation: Suggested Citation