Arbitrage-Free Affine Models of the Forward Price of Foreign Currency

29 Pages Posted: 3 Mar 2014

Date Written: February 1, 2014

Abstract

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

Durham, J. Benson, Arbitrage-Free Affine Models of the Forward Price of Foreign Currency (February 1, 2014). FRB of New York Staff Report No. 665. Available at SSRN: https://ssrn.com/abstract=2403926 or http://dx.doi.org/10.2139/ssrn.2403926

J. Benson Durham (Contact Author)

Cornerstone Macro LLC ( email )

1330 Sixth Avenue, 5th Floor
New York, NY 10019
United States

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