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The Forward Premium Puzzle Revisited

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  • Guy Meredith
  • Yue Ma
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Abstract

The forward premium is a notoriously poor predictor of exchange rate movements. This failure must reflect deviations from risk neutrality and/or rational expectations. In addition, a mechanism is needed that generates the appropriate correlation between the forward premium and shocks arising from risk premia or expectations errors. This paper extends McCallum (1994) to show how such a correlation can arise from the response of monetary policy to output and inflation, which are in turn affected by the exchange rate. The theoretical models considered all generate results that are consistent with the forward premium being a biased predictor of short-term exchange rate movements; the bias decreases, however, as the horizon of the exchange rate change lengthens. Another common feature of the models is that the true reduced-form equation for exchange rate changes contains variables other than the interest differential, providing a justification for "eclectic" relationships for forecasting exchange rates. The results, however, remain consistent with using uncovered interest parity as a building block for structural models.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 02/28.

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Length: 39
Date of creation: 01 Feb 2002
Date of revision:
Handle: RePEc:imf:imfwpa:02/28

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Related research

Keywords: Exchange rates; exchange rate; equation; correlation; exchange rate changes; equations; exchange rate movements; real exchange rate; exchange rate change; exchange markets; standard deviations; exchange rate appreciation; samples; forecasting; sample size; covariances; foreign exchange; autocorrelation; sample sizes; sampling; exchange rate regimes; standard errors; covariance; statistics; standard deviation; nominal exchange rate; foreign exchange markets; forward exchange; random variables; sampling error; random number; floating exchange rate; random number generator; causation; floating correlations; floating exchange rate regimes; volatility in forward exchange rate; real numerical values; current exchange rate; linear model; dynamic linear model; exchange rate shocks; forward spot exchange rate; analytical methods; calibration; sampling distribution; effect of exchange rate changes; sample bias; parameter estimate; finite sample; stochastic model; population parameter; linear models; exchange rate economics; orthogonality; simulation results;

References

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  1. Baillie, Richard T. & Bollerslev, Tim, 2000. "The forward premium anomaly is not as bad as you think," Journal of International Money and Finance, Elsevier, Elsevier, vol. 19(4), pages 471-488, August.
  2. Kaushik Mitra & James Bullard, . "Learning About Monetary Policy Rules," Discussion Papers, Department of Economics, University of York 00/41, Department of Economics, University of York.
  3. McCallum, Bennett T., 1998. "Solutions to linear rational expectations models: a compact exposition," Economics Letters, Elsevier, Elsevier, vol. 61(2), pages 143-147, November.
  4. Froot, Kenneth A & Thaler, Richard H, 1990. "Foreign Exchange," Journal of Economic Perspectives, American Economic Association, American Economic Association, vol. 4(3), pages 179-92, Summer.
  5. Bennett T. McCallum, 1981. "On Non-Uniqueness in Rational Expectations Models: An Attempt at Perspective," NBER Working Papers 0684, National Bureau of Economic Research, Inc.
  6. Bennett T. McCallum, 1992. "A Reconsideration of the Uncovered Interest Parity Relationship," NBER Working Papers 4113, National Bureau of Economic Research, Inc.
  7. Olivier Jeanne & Andrew K. Rose, 2002. "Noise Trading And Exchange Rate Regimes," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 117(2), pages 537-569, May.
  8. Richard Clarida & Jordi Gali & Mark Gertler, 2001. "Optimal Monetary Policy in Closed versus Open Economies: An Integrated Approach," NBER Working Papers 8604, National Bureau of Economic Research, Inc.
  9. Alexius, Annika, 2001. "Uncovered Interest Parity Revisited," Review of International Economics, Wiley Blackwell, Wiley Blackwell, vol. 9(3), pages 505-17, August.
  10. 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.
  11. Douglas Laxton & Michael Bleany, 1999. "Real Interest Rates and Real Exchange Rates : Evidence from Indexed Bonds," Computing in Economics and Finance 1999, Society for Computational Economics 942, Society for Computational Economics.
  12. Nelson C. Mark & Yangru Wu, 1996. "Risk, Policy Rules, and Noise: Rethinking Deviations From Uncovered Interest Parity," Working Papers, Ohio State University, Department of Economics 014, Ohio State University, Department of Economics.
  13. Flood, Robert P & Rose, Andrew K, 1996. "Fixes: Of the Forward Discount Puzzle," The Review of Economics and Statistics, MIT Press, vol. 78(4), pages 748-52, November.
  14. Guy Meredith & Menzie D. Chinn, 1998. "Long-Horizon Uncovered Interest Rate Parity," NBER Working Papers 6797, National Bureau of Economic Research, Inc.
  15. McCallum, Bennett T. & Nelson, Edward, 1998. "Nominal Income Targeting in an Open-Economy Optimizing Model," Seminar Papers, Stockholm University, Institute for International Economic Studies 644, Stockholm University, Institute for International Economic Studies.
  16. Ma, Yue, 1992. "Policy Measurement for the Dynamic Linear Model with Expectations Variables: A Multiplier Approach," Computer Science in Economics & Management, Society for Computational Economics, Society for Computational Economics, vol. 5(4), pages 303-12, November.
  17. Tiff Macklem, R., 1991. "Forward exchange rates and risk premiums in artificial economies," Journal of International Money and Finance, Elsevier, Elsevier, vol. 10(3), pages 365-391, September.
  18. Lewis, Karen K., 1995. "Puzzles in international financial markets," Handbook of International Economics, Elsevier, in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 37, pages 1913-1971 Elsevier.
  19. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, Elsevier, vol. 39(1), pages 195-214, December.
  20. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, Econometric Society, vol. 48(5), pages 1305-11, July.
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Citations

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Cited by:
  1. Kashif Mansori, 2003. "Following in their Footsteps: Comparing Interest Parity Conditions in Central European Economies to the Euro Countries," CESifo Working Paper Series 1020, CESifo Group Munich.
  2. Engel, Charles & West, Kenneth D., 2006. "Taylor Rules and the Deutschmark: Dollar Real Exchange Rate," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 38(5), pages 1175-1194, August.

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