Forward Exchange Rates and Expected Future Spot Rates

In this paper I explore whether knowledge of the time-series properties of premia in the pricing of forward foreign exchange can be usefully exploited in forecasting future spot exchange rates. I use signal-extraction techniques, based on recursive application of the Kalman filter, to identify these premia. Predictions using premium models compare favourably with those obtained from the use of the forward rate as a predictor of the future spot rate. The results also provide an interesting description of the time-series properties of premia. This methodology can be applied straightforwardly to other financial markets, such as futures markets and markets for government debt instruments.