Currency Futures-Spot Basis and Risk Premium

Posted: 24 Jan 2006

See all articles by A. Can Inci

A. Can Inci

Bryant University

Biao Lu

University of Michigan at Ann Arbor

Abstract

This paper explores the usefulness of currency futures-spot basis in predicting spot rate changes and currency futures returns. We conjecture that the currency risk premium may be an important component of the basis for long-maturity futures contracts, but may not be so for short-maturities. Thus, the basis of long-maturity contracts cannot predict the spot rate changes between now and maturity, rejecting uncovered interest rate parity (UIP), but can predict currency futures returns, which are solely determined by the risk premium. Conversely, the basis of the short-maturity contracts can predict the spot rate changes between now and maturity, validating the UIP, but cannot predict currency futures returns. Empirical tests support these conjectures for the Japanese, British, Swiss, and German currencies over the last two decades. The results are also consistent with Longstaff [Longstaff, F., 2000. The term structure of very short-term rates: new evidence for the Expectation Hypothesis. Journal of Financial Economics 58, 397-415], who shows that the Expectations Hypothesis holds at the very short end of the term structure of interest rates.

Keywords: Currency futures, Exchange rates, Risk premium

JEL Classification: G13, F31, G14

Suggested Citation

Inci, Ahmet Can and Lu, Biao, Currency Futures-Spot Basis and Risk Premium. Journal of International Financial Markets, Institutions, and Money, Vol. 17, pp. 180-197, 2007, Available at SSRN: https://ssrn.com/abstract=877222

Ahmet Can Inci (Contact Author)

Bryant University ( email )

1150 Douglas Pike
Smithfield, RI 02917
United States

Biao Lu

University of Michigan at Ann Arbor ( email )

500 S. State Street
Ann Arbor, MI 48109
United States

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