The term structure of forward premia

We study the forward premia implicit in the term structure of forward exchange rates including time-varying risk premia which vary systematically with risk. Different from most other studies on a foreign exchange market, we focus on the joint behavior of forward exchange rates of different maturities. We relate the forward premium to a swap rate, the price of a foreign exchange swap contract. In swap transactions, traders are only interested in forward premia. Since the forward premium itself exhibits significant volatility, speculative transactions using the uncertainty of a future forward premium become more important in forward exchange markets, and it is expected that such behaviors are reflected in an equilibrium forward exchange rates. Therefore we attempt to explain the risk premium as an expected return on a foreign exchange swap speculation, and investigate whether or not the existence of the risk premium can explain the determination of forward premiums across maturities. We find that the risk premia implied in the term structure are time-varying and the term structure variables have non-trivial information on the risk premia as well as the future forward premia.;We also attempt to identify the macoreconomic sources of the risk premium by constructing a simple monetary general equilibrium model of the term structure with a cash-in-advance constraint. We use a very general specification for the time series behaviors of macroeconomic variables using a multivariate vector autoregressive representation. The model shows how the forecast-error variance associated with macroeconomic variables interact with the risk aversion of economic agents to cause movement in risk premiums over time. By estimating the model, we find that the forecast-error variance of some macroeconomic variables is time-varying and significantly affects the determination of the risk premium. However, the over-identifjing restrictions imposed by our model are rejected and the time-variations of ex-ante risk premia are found to be much smaller than the time-variations of ex-post risk premia.