Description

Using monthly data for the United States dolla r – New Zealand dollar exchange rate, this paper revisits the forward premium puzzle and applies a discrete no-ar bitrage affine model of the term structure of interest rates to obtain historical estimates of the time-varying foreign exchange risk premium. The two-fact or model is estimated via maximum likelihood for the period 1995-2006. The results of this study demonstrate that the modeled risk premium satisfies the required Fama’s condi tions, and its inclusion in an extended GARCH(1,1) model is significant in explaining both the mean and the volatility of the exchange rate. However, consistently with the extant literature, the estimated risk premium does not preclude the presence of the forw ard premium anomaly. Lastly, out-of-sample forecasts of the exchange rate for different specifications and time periods reveal that predictions of the proposed model for the exch ange rate are far from the accuracy of a simple random walk specification.