Factors of the term structure of realized risk premiums in the Australian currency forward market

We examine the term structure of realized risk premiums in the Australian Dollar–US Dollar forward market and document that these premiums are positive, time-varying, and increasing with contract maturity. We show that realized variance, skewness, and kurtosis of spot exchange rate returns are significant determinants of the risk premiums across horizons. Using principal component analysis, we extract a small set of latent factors that explain over 90% of the variation in the term structure, which can be naturally interpreted as level, slope, and curvature factors and can be related to the realized variance, kurtosis and skewness of spot exchange rate returns. An important contribution of the paper is to show that these factors play a central role in reconciling the forward premium anomaly. In standard Fama regressions, the forward–spot spread yields negative slope coefficients; however, when the extracted factors are included, the coefficients move sharply toward the UIP-consistent benchmark of one across all maturities. Moreover, the lagged values of the factors exhibit substantial predictive power for future risk premiums, far exceeding that of traditional predictors such as realized variance, skewness, and kurtosis. These results highlight that the dynamics of currency risk premiums are driven by a small set of persistent global and local forces shaping the term structure, offering an integrated explanation for both the cross-sectional and time-series behaviour of forward premiums.