A SIMPLE CHARACTERIZATION AND TEST OF THE FORWARD EXCHANGE PREMIUM

Abstract

Literature on forward foreign exchange rates recognises that forward rates can contain premiums as well as market forecasts of future spot rates. This paper proposes and implements a simple test for the existence of varying forward exchange premiums in several currencies quoted on the International Monetary Market CIMM> of the Chicago Mercantile Exchange for the period 1976 to 1966. The results obtained suggest that varying forward exchange premiums are statistically insignificant for all the currencies tested. Since the variations in premium may be small but not non-existent, the paper proceeds to characterise the premium using regression analysis. The variables for the regression analysis are derived From the Interest Rate Parity Theorem. The regression equations obtained for all the currencies have high and significant coefficients of determination. That is, they provide good characterization of the premiums.