Systematic Risks, Speculators and the Forward Rate Puzzle

An often-cited explanation for the forward rate puzzle is that predictions obtained under risk neutrality do notapply in a world where the typical agent is risk averse. Thus, ignoring risk premiums in empirical testing amounts tomisspecification, which may unduly influence the estimated coefficients. Whether risk premiums exist in currencymarkets is especially important to those exposed to international commodity and financial markets, as there areimplications for both hedging strategies and the expectations formation process. This paper focuses upon two possiblesources of premia, namely systematic risk arising from market portfolio risk and secondly, the influence of speculativepressures upon currency markets. Perusal of the literature finds support for the importance of both these above sources,yet strangely no research seems to place them together and in the context of the forward rate puzzle. There is evidence tosuggest that systematic risks do arise from currency exposure, but that the marginal speculator cannot impose a premiumupon the currency market. Furthermore, we compare the results from two sets of estimators, namely OLS and IV, due toour reliance upon proxy variables. While there is little substantive difference in the two sets of results, it does improveupon historical practices, which typically ignore the problems introduced by proxy variables. Another interestingextension is to determine whether incorporation of risk premiums can improve currency forecasts. We attempt to mimicthe conditions faced by those in the marketplace through implementation of recursive techniques. We find that evaluatingforecasts using standard criteria suggests that using risk premiums does not assist in forecasting future spot exchangerates.