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Understanding the Forward Premium Puzzle: A Microstructure Approach

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  • Burnside, A Craig
  • Eichenbaum, Martin
  • Rebelo, Sérgio

Abstract

High-interest-rate currencies tend to appreciate relative to low-interest-rate currencies. We argue that adverse-selection problems between participants in foreign exchange markets can account for this `forward premium puzzle.' The key feature of our model is that the adverse selection problem facing market makers is worse when, based on public information, a currency is expected to appreciate.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 6399.

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Date of creation: Jul 2007
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Handle: RePEc:cpr:ceprdp:6399

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Keywords: Exchange rates; microstructure; Uncovered interest parity;

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  1. Lawrence R. Glosten & Paul R. Milgrom, 1983. "Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders," Discussion Papers, Northwestern University, Center for Mathematical Studies in Economics and Management Science 570, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  2. Rui Albuquerque & Gregory H. Bauer & Martin Schneider, 2004. "International Equity Flows and Returns: A Quantitative Equilibrium Approach," Working Papers 04-42, Bank of Canada.
  3. Philippe Bacchetta & Eric van Wincoop, 2006. "Incomplete information processing: a solution to the forward discount puzzle," Proceedings, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco, issue Jun.
  4. Giancarlo Corsetti & Amil Dasgupta & Stephen Morris & Hyun Song Shin, 2001. "Does one Soros make a difference?: a theory of currency crises with large and small traders," LSE Research Online Documents on Economics, London School of Economics and Political Science, LSE Library 25045, London School of Economics and Political Science, LSE Library.
  5. Rui Albuquerque & Eva De Francisco & Luis B. Marques, 2008. "Marketwide Private Information in Stocks: Forecasting Currency Returns," Journal of Finance, American Finance Association, American Finance Association, vol. 63(5), pages 2297-2343, October.
  6. Massa, Massimo & Simonov, Andrei, 2003. "Reputation and interdealer trading: a microstructure analysis of the Treasury Bond market," Journal of Financial Markets, Elsevier, Elsevier, vol. 6(2), pages 99-141, April.
  7. Han, Bing & Hirshleifer, David & Wang, Tracy Yue, 2005. "Investor Overconfidence and the Forward Discount Puzzle," Working Paper Series 2005-21, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
  8. Giancarlo Corsetti & Amil Dasgupta & Stephen Morris & Shin, Hyun, 2000. "Does One Soros Make a Difference? A Theory of Currency Crises with Large and Small Traders," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 1273, Cowles Foundation for Research in Economics, Yale University.
  9. Hansen, Lars Peter & Singleton, Kenneth J, 1982. "Generalized Instrumental Variables Estimation of Nonlinear Rational Expectations Models," Econometrica, Econometric Society, Econometric Society, vol. 50(5), pages 1269-86, September.
  10. Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, Elsevier, vol. 3(2), pages 123-192, June.
  11. Rui Albuquerque & Gregory H. Bauer & Martin Schneider, 2007. "International Equity Flows and Returns: A Quantitative Equilibrium Approach -super-1," Review of Economic Studies, Oxford University Press, vol. 74(1), pages 1-30.
  12. Michael J. Fleming, 1997. "The round-the-clock market for U.S. Treasury securities," Economic Policy Review, Federal Reserve Bank of New York, Federal Reserve Bank of New York, issue Jul, pages 9-32.
  13. Bansal, Ravi & Dahlquist, Magnus, 1999. "The Forward Premium Puzzle: Different Tales from Developed and Emerging Economies," CEPR Discussion Papers, C.E.P.R. Discussion Papers 2169, C.E.P.R. Discussion Papers.
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