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Estimating a Latent Risk Premium in Exchange Rate Futures

Discussion Papers 1733, 43 S.

Kerstin Bernoth, Jürgen von Hagen, Casper G. de Vries


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Using exchange rates futures instead of forwards completes the maturity spectrum of the correlation between the spot return and the premium. The correlation decreases with increasing maturity, presumably due to a latent risk premium. We hypothesize that the influence of the unobserved risk factor has a contract-specific risk component. Our main contribution is to control for the omitted variable bias by using a modified version of the CCE panel estimator in combination with futures data. This renders the coefficient on the futures premium insignificantly different from one. Subsequently, the contract-specific part is related to conventional proxies of risk.

Kerstin Bernoth

Deputy Head of Department in the Macroeconomics Department

JEL-Classification: F31;F37;G13
Keywords: Forward premium puzzle, CCE estimation, futures rates, latent risk
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