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Monetary Policy Shifts and the Forward Discount Puzzle

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  • Michael Jetter

    ()

  • Alex Nikolsko-Rzhevskyy

    ()

Abstract

This paper argues that considerable switches in monetary policy are able to explain a major part of the forward discount puzzle. We build a theoretical model suggesting that violations of the uncovered interest rate parity are owed to shifts in monetary policy from a destabilizing (when the Taylor principle is violated) to a stabilizing regime (when a central bank follows a Taylor-type rule). Following the switch is an adjustment period" during which forecasters gradually update their expectations, eventually restoring the parity. It is in this adjustment period, when the forward discount puzzle arises. In the second part of the paper we test the model on the Canadian dollar, German mark, and British pound, all against the US dollar. Results indicate that the forward discount puzzle loses signi cance after allowing for an adjustment period of about 1 - 2 years. Our results are robust to various di erent speci cations, such as the use of di erent maturities or base currencies. Further, it seems unlikely that our results coincide with contemporaneous events.

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File URL: http://repository.eafit.edu.co/bitstream/10784/746/1/2013_9_Michael_Jetter.pdf
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Bibliographic Info

Paper provided by UNIVERSIDAD EAFIT in its series DOCUMENTOS DE TRABAJO CIEF with number 010729.

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Length: 22
Date of creation: 13 Apr 2013
Date of revision:
Handle: RePEc:col:000122:010729

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Keywords: expectations errors; excess returns; forward discount puzzle; Taylor rule; monetary policy;

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References

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  1. Richard Clarida & Jordi Gali & Mark Gertler, 1997. "Monetary Policy Rules in Practice: Some International Evidence," NBER Working Papers 6254, National Bureau of Economic Research, Inc.
  2. Philippe Bacchetta & Eric van Wincoop, 2007. "Random Walk Expectations and the Forward Discount Puzzle," NBER Working Papers 13205, National Bureau of Economic Research, Inc.
  3. Alex Nikolsko‐Rzhevskyy, 2011. "Monetary Policy Estimation in Real Time: Forward‐Looking Taylor Rules without Forward‐Looking Data," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 43(5), pages 871-897, 08.
  4. Charles Engel, 1995. "The Forward Discount Anomaly and the Risk Premium: A Survey of Recent Evidence," NBER Working Papers 5312, National Bureau of Economic Research, Inc.
  5. Philippe Bacchetta & Eric van Wincoop, 2010. "Infrequent Portfolio Decisions: A Solution to the Forward Discount Puzzle," American Economic Review, American Economic Association, vol. 100(3), pages 870-904, June.
  6. Sakoulis, Georgios & Zivot, Eric & Choi, Kyongwook, 2010. "Structural change in the forward discount: Implications for the forward rate unbiasedness hypothesis," Journal of Empirical Finance, Elsevier, vol. 17(5), pages 957-966, December.
  7. Kenneth A. Froot and Jeffrey A. Frankel., 1988. "Forward Discount Bias: Is It an Exchange Risk Premium?," Economics Working Papers 8874, University of California at Berkeley.
  8. Adrien Verdelhan, 2006. "A Habit-Based Explanation of the Exchange Rate Risk Premium," 2006 Meeting Papers 872, Society for Economic Dynamics.
  9. James R. Lothian & Liuren Wu, 2003. "Uncovered Interest Rate Parity Over the Past Two Centuries," International Finance 0311009, EconWPA.
  10. Sarantis, Nicholas, 2006. "Testing the uncovered interest parity using traded volatility, a time-varying risk premium and heterogeneous expectations," Journal of International Money and Finance, Elsevier, vol. 25(7), pages 1168-1186, November.
  11. Lustig, H. & Verdelhan, A., 2006. "The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk," Working papers 155, Banque de France.
  12. Fernando Alvarez & Andrew Atkeson & Patrick J. Kehoe, 2005. "Time-varying risk, interest rates and exchange rates in general equilibrium," Working Papers 627, Federal Reserve Bank of Minneapolis.
  13. Seongman Moon & Carlos Velasco, 2011. "The Forward Discount Puzzle: Identi cation of Economic Assumptions," Working Papers 1112, Research Institute for Market Economy, Sogang University.
  14. Choi, Kyongwook & Zivot, Eric, 2007. "Long memory and structural changes in the forward discount: An empirical investigation," Journal of International Money and Finance, Elsevier, vol. 26(3), pages 342-363, April.
  15. Molodtsova, Tanya & Nikolsko-Rzhevskyy, Alex & Papell, David H., 2008. "Taylor rules with real-time data: A tale of two countries and one exchange rate," Journal of Monetary Economics, Elsevier, vol. 55(Supplemen), pages S63-S79, October.
  16. Mark, Nelson C & Wu, Yangru, 1998. "Rethinking Deviations from Uncovered Interest Parity: The Role of Covariance Risk and Noise," Economic Journal, Royal Economic Society, vol. 108(451), pages 1686-1706, November.
  17. Gourinchas, Pierre-Olivier & Tornell, Aaron, 2004. "Exchange rate puzzles and distorted beliefs," Journal of International Economics, Elsevier, vol. 64(2), pages 303-333, December.
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