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Intertemporal Risk in the Foreign Currency Futures Basis

We investigate covariation of payoffs from spot and futures positions in foreign currency markets. The weights in a hedged position are determined by the prices of futures and spot contracts and by foreign and domestic interest rates. Evaluating this hedged position using an intertemporal asset-pricing model leads to a testable equilibrium model of the futures basis. Systematic intertemporal risk will be proportional to the conditional covariance of the basis with a generalized discount factor. Empirical implementation uses a conditional capital-asset-pricing model (CAPM) in which both the quantity and the price of covariance risk are free to vary over time. However, for this application, the estimated intertemporal risk is insignificantly different from zero, the risk in the futures market offsets that in the spot, providing an effective hedge.