Forward Discount Bias, Nalebuff's Envelope Puzzle, and the Siegel Paradox in Foreign Exchange
AbstractThe bias of forward exchange rates as a predictor of future spot rates is typically explained or decomposed as (1) a risk premium and (2) a convexity term which accounts for the fact that, when there is stochastic inflation, nominal gains from forward currency speculation are higher than real ones and correspondingly losses are smaller. We use Nalebuff's envelope puzzle to explain a third source of bias which involves real profits from foreign exchange speculation. Both the "real profit" bias and stochastic inflation bias arise from convexity of g(s)=1/s and so derive from Jensen's inequality as observed by Siegel (1972).
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Bibliographic InfoPaper provided by Berkeley Olin Program in Law & Economics in its series Berkeley Olin Program in Law & Economics, Working Paper Series with number qt2wc1p9pw.
Date of creation: 01 Jun 2002
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