Time-varying betas and risk premia in the pricing of forward foreign exchange contracts

Abstract

This paper specifies the single-beta capital asset pricing model for the pricing of forward foreign exchange contracts from the point of view of a U.S. investor. Parametric specification of the betas as ARCH-like processes explicitly allows for time variation as well as sign variation of the risk premium in the forward foreign exchange market. I estimate the model jointly for four currencies, using a generalized method of moments procedure. The results show significant time variation for the betas and tests of the overidentifying restrictions are generally favorable to the model.