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The Term-Structure of Risk and Forward Premiums in Currency Futures Markets

Speaker:  Satish Kumar, IFHE University, Hyderabad, India

Date: Wednesday 30 May

Time: 12pm-1pm

Venue: E4A 623

Abstract: We examine the term-structure of forward premiums and realized risk premiums in five major currency futures markets. While a large body of literature investigates the term structure of interest rates few have analyzed the dynamics of forward premiums for exchange rates at different maturities. We use principal component analysis to examine the dynamics of these high-dimensional time series and intend to explain their dynamics through a smaller number of common factors. For the forward premium term structure, we find that two factors are sufficient to explain approximately 99% of the total variation. These factors are highly correlated to the level and slope of the forward premium curve and can also be related to financial and macroeconomic variables. Based on the derived factors we then produce forecasts of the forward premium for different maturities at both short and long horizons. For the term structure of realized risk premiums we obtain a four-factor model that explains a high percentage of the total variation. The first three factors can be suitably labelled as ‘level’, ‘slope’ and ‘curvature’ as suggested by e.g. Die bold and Li (2005). Our results provide important insights on the nature and dynamics of forward and risk premiums for participants in currency future markets.