Report

Arbitrage-free affine models of the forward price of foreign currency

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;

Bibliographic Information

Provider: Federal Reserve Bank of New York

Part of Series: Staff Reports

Publication Date: 2014-02-01

Number: 665