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A New Look at the Forward Premium Puzzle

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  • Nikolay Gospodinov

Abstract

This paper analyzes the sampling properties of the widely documented large negative slope estimates in regressions of future exchange returns on current forward premium. We argue that the abnormal behavior of the slope estimators in these regressions arises from the simultaneous presence of high persistence, low signal-to-noise ratio, strong endogeneity, and an omitted variable problem. The paper develops the limiting theory for the slope parameter estimators in the levels and differenced forward premium regressions under some assumptions that match the empirical properties of the data. The asymptotic results derived in the paper help to reconcile the findings from the levels and difference specifications and provide important insights about the time-series properties of the implied risk premium. Copyright The Author 2009. Published by Oxford University Press. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.

Suggested Citation

  • Nikolay Gospodinov, 2009. "A New Look at the Forward Premium Puzzle," Journal of Financial Econometrics, Oxford University Press, vol. 7(3), pages 312-338, Summer.
    • Handle: RePEc:oup:jfinec:v:7:y:2009:i:3:p:312-338
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    File URL: http://hdl.handle.net/10.1093/jjfinec/nbp002
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    Cited by:

    1. Frankel, Jeffrey & Poonawala, Jumana, 2010. "The forward market in emerging currencies: Less biased than in major currencies," Journal of International Money and Finance, Elsevier, vol. 29(3), pages 585-598, April.
    2. Gourieroux, Christian & Jasiak, Joann, 2010. "Inference for Noisy Long Run Component Process," MPRA Paper 98987, University Library of Munich, Germany.
    3. Bai, Shuming & Mollick, Andre Varella, 2010. "Currency crisis and the forward discount bias: Evidence from emerging economies under breaks," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 20(5), pages 556-574, December.
    4. Raj Aggarwal & Brian M. Lucey & Fergal A. O'Connor, 2014. "Rationality in Precious Metals Forward Markets: Evidence of Behavioural Deviations in the Gold Markets," The Institute for International Integration Studies Discussion Paper Series iiisdp462, IIIS.
    5. Cheung, Yin-Wong & Wang, Wenhao, 2022. "Uncovered interest rate parity redux: Non-uniform effects," Journal of Empirical Finance, Elsevier, vol. 67(C), pages 133-151.
    6. Aziz Chouikh & Abdelwahed Trabelsi, 2014. "Modeling Risk Premia in Forward Foreign Exchange Rates as Unobserved Components: The Model Identification Problem," International Journal of Financial Research, International Journal of Financial Research, Sciedu Press, vol. 5(3), pages 119-135, July.
    7. Carmen Gloria Silva, 2010. "Forward premium puzzle and term structure of interest rates: the case of New Zealand," Working Papers Central Bank of Chile 570, Central Bank of Chile.
    8. Jamali, Ibrahim & Yamani, Ehab, 2019. "Out-of-sample exchange rate predictability in emerging markets: Fundamentals versus technical analysis," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 61(C), pages 241-263.
    9. Shang, Hua, 2013. "Inference in asset pricing models with a low-variance factor," Journal of Banking & Finance, Elsevier, vol. 37(3), pages 1046-1060.
    10. Shehadeh, Ali A. & Li, Youwei & Vigne, Samuel A. & Almaharmeh, Mohammad I. & Wang, Yizhi, 2021. "The existence and severity of the forward premium puzzle during tranquil and turbulent periods: Developed versus developing country currencies," International Review of Financial Analysis, Elsevier, vol. 78(C).
    11. Stanislav Anatolyev & Nikolay Gospodinov, 2012. "Asymptotics of near unit roots (in Russian)," Quantile, Quantile, issue 10, pages 57-71, December.
    12. Stanislav Anatolyev & Nikolay Gospodinov & Ibrahim Jamali & Xiaochun Liu, 2015. "Foreign exchange predictability during the financial crisis: implications for carry trade profitability," FRB Atlanta Working Paper 2015-6, Federal Reserve Bank of Atlanta.
    13. Matei Demetrescu & Christoph Roling & Anna Titova, 2021. "Reevaluating the prudence of economic forecasts in the EU: The role of instrument persistence," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 36(1), pages 151-161, January.
    14. Christian Gourieroux & Joann Jasiak, 2022. "Long Run Risk in Stationary Structural Vector Autoregressive Models," Papers 2202.09473, arXiv.org.
    15. Shehadeh, Ali & Li, Youwei & Moore, Michael, 2016. "The Forward Premium Bias, Carry Trade Return and the Risks of Volatility and Liquidity," MPRA Paper 71709, University Library of Munich, Germany.
    16. Phillips, Peter C.B. & Lee, Ji Hyung, 2013. "Predictive regression under various degrees of persistence and robust long-horizon regression," Journal of Econometrics, Elsevier, vol. 177(2), pages 250-264.
    17. Norman C. Miller, 2014. "Exchange Rate Economics," Books, Edward Elgar Publishing, number 14981.
    18. Anatolyev, Stanislav & Gospodinov, Nikolay & Jamali, Ibrahim & Liu, Xiaochun, 2017. "Foreign exchange predictability and the carry trade: A decomposition approach," Journal of Empirical Finance, Elsevier, vol. 42(C), pages 199-211.

    More about this item

    JEL classification:

    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • F31 - International Economics - - International Finance - - - Foreign Exchange

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