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A New Look at the Forward Premium Puzzle

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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.

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File URL: http://alcor.concordia.ca/~gospodin/research/forwprem.pdf
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Bibliographic Info

Paper provided by Concordia University, Department of Economics in its series Working Papers with number 08009.

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Length: 36 pages
Date of creation: Sep 2006
Date of revision: Dec 2008
Handle: RePEc:crd:wpaper:08009

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Keywords: Forward premium anomaly; high persistence; low signal-to-noise ratio; local-to-unity asymptotics;

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Cited by:
  1. 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.
  2. Frankel, Jeffrey A. & Poonawala, Jumana, 2009. "The Forward Market in Emerging Currencies: Less Biased than in Major Currencies," Scholarly Articles 4448888, Harvard Kennedy School of Government.
  3. 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.
  4. 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.
  5. Shang, Hua, 2013. "Inference in asset pricing models with a low-variance factor," Journal of Banking & Finance, Elsevier, vol. 37(3), pages 1046-1060.

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