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Using monthly data for the United States dollar - New Zealand dollar exchange rate, this paper revisits the forward premium puzzle and applies a discrete no-arbitrage affine model of the term structure of interest rates to obtain historical estimates of the time-varying foreign exchange risk premium. The two-factor model is estimated via maximum likelihood for the period 1995-2006. The results of this paper demonstrate that the modeled risk premium satisfies the required Fama's conditions, and its inclusion in an extended GARCH(1,1) model is significant in explaining both the mean and the volatility of the exchange rate.
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