Determinants of Forward Exchange Rate and the Role of Risk Premiums (Case of CZK/EUR and CZK/USD Parities)

Abstract

Determinants of Forward Exchange Rate and the Role of Risk Premiums (Case of CZK/EUR and CZK/USD Parities) The aim of the article is to examine the relations between forward exchange rates (maturities of 3 and 6 months), spot exchange rates, interest rate differentials, expected spot exchange rates and risk premiums on the CZK/EUR and CZK/USD parities. A model of FX speculators and arbitrageurs is devised and subsequently empirically verified in order to provide an explanation for the dynamics of forward exchange rates. The estimations of parameters of explanatory variables, which enter the covered interest rate parity, are confirmed to be statistically significant for the time period preceding the application of the exchange rate commitment by the Czech National Bank. Though the estimated parameters of future spot rates are statistically significant, their low values suggest that their impact on the quotation of forward exchange rates is rather marginal. The statistically significant estimations of constants with negative signs are interpreted as risk premiums reflecting the higher credit risk for financial investments denominated in CZK. The relations within the time series of the CZK/EUR parity were found to be distorted during the period of exchange rate commitment on the parity level of 27 CZK/EUR and during foreign exchange interventions (i.e., the estimated parameters of interest rate differentials were not statistically significant).