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Federal Reserve Bank of New York
Staff Reports
Arbitrage-free affine models of the forward price of foreign currency
J. Benson Durham
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.


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J. Benson Durham, Arbitrage-free affine models of the forward price of foreign currency, Federal Reserve Bank of New York, Staff Reports 665, 01 Feb 2014.
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Keywords: arbitrage-free model; foreign exchange
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