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Forward Discount Puzzle and Liquidity Effects: Some Evidence from Exchange Rates among the United States, Canada, and Japan

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  • Fukuta, Yuichi
  • Saito, Makoto

Abstract

This paper empirically examines whether the interaction between foreign exchange markets and monetary markets can help to resolve the forward discount puzzle. Following the monetary models of Lucas (1990) and Fuerst (1992), we define as liquidity effects (the negative impact of monetary injection on nominal interest rates), temporary deviations from the standard Euler equation. The liquidity effect identified by these models weakens the linkage between current forward rates and expected future spot rates, and improves on the standard rational expectations model that predicts a one-to-one correspondence between the two. Using time series of exchange rates among the United States, Canada, and Japan, this paper shows that the liquidity measure identified above has an impact on forward premiums, and that once the liquidity effect is taken into consideration, the unbiased prediction of the forward discount rate is recovered to some extent in a theoretically consistent manner.

Suggested Citation

  • Fukuta, Yuichi & Saito, Makoto, 2002. "Forward Discount Puzzle and Liquidity Effects: Some Evidence from Exchange Rates among the United States, Canada, and Japan," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 34(4), pages 1014-1033, November.
    • Handle: RePEc:mcb:jmoncb:v:34:y:2002:i:4:p:1014-33
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    Cited by:

    1. Nagayasu, Jun, 2012. "Long-Run Implications of the Covered Interest Rate Parity Condition: Evidence during the Recent Crisis and Non-Crisis Periods," MPRA Paper 41566, University Library of Munich, Germany.
    2. Nagayasu, Jun, 2011. "The threshold nonstationary panel data approach to forward premiums," MPRA Paper 34265, University Library of Munich, Germany.
    3. Kiyohiko G. Nishimura & Makoto Saito, 2003. "On Alternatives to Aggressive Demand Policies to Revitalize the Japanese Economy," Asian Economic Papers, MIT Press, vol. 2(3), pages 87-126.
    4. Murphy, Austin, 2008. "An empirical investigation of investor expectations in the currency market," International Review of Financial Analysis, Elsevier, vol. 17(1), pages 108-133.
    5. Murphy, Austin & Zhu, Yun (Ellen), 2008. "Unraveling the complex interrelationships between exchange rates and fundamentals," Journal of Banking & Finance, Elsevier, vol. 32(6), pages 1150-1160, June.
    6. Jorge Braga de Macedo & Luis Brites Pereira, 2006. "The credibility of Cabo Verde’s currency peg," Nova SBE Working Paper Series wp494, Universidade Nova de Lisboa, Nova School of Business and Economics.

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