The Term Structure of Currency Futures' Risk Premia

Abstract

The use of futures exchange contracts instead of forwards completes the maturity
spectrum of the correlation between the spot yield and the premium. We find that the
forward premium puzzle (FPP) depends significantly on the maturity horizon of the
futures contract and the choice of the sampling period. The FPP appears to be a pre-
crisis phenomenon and is only observed for maturities longer than about one month.
We find that differences in the exposure to risk help to explain the cross-sectional spread
in currency excess returns in a significant way. Currencies with a low futures premium
are less exposed to market, consumption and carry trade risk than currencies with a
high futures premium. However, this only applies for medium and longer asset matu-
rities. Considering that most studies that test the validity of a risk-based approach to
currency excess returns focus on short maturity securities, our results explains why this
approach is so often rejected.

Keywords: forward premium puzzle, uncovered interest parity, futures rates, price of risk, currency excess returns, capital asset pricing model

JEL Classification: F31, F37, G12, G13, G15