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The Forward Premium Puzzle in a Two-Country World

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  • Ian Martin

Abstract

I explore the behavior of asset prices and the exchange rate in a two-country world. When the large country has bad news, the relative price of the small country’s output declines. As a result, the small country’s bonds are risky, and uncovered interest parity fails, with positive excess returns available to investors who borrow at the large country’s interest rate and lend at the small country’s interest rate. I use a diagrammatic approach to derive these and other results in a calibration-free way.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17564.

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Date of creation: Nov 2011
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Handle: RePEc:nbr:nberwo:17564

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References

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  1. Ian Martin, 2013. "The Lucas Orchard," Econometrica, Econometric Society, Econometric Society, vol. 81(1), pages 55-111, 01.
  2. Craig Burnside & Martin Eichenbaum & Isaac Kleshchelski & Sergio Rebelo, 2011. "Do Peso Problems Explain the Returns to the Carry Trade?," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 24(3), pages 853-891.
  3. Jordà, Òscar & Taylor, Alan M., 2012. "The carry trade and fundamentals: Nothing to fear but FEER itself," Journal of International Economics, Elsevier, Elsevier, vol. 88(1), pages 74-90.
  4. Ian Martin, 2010. "Consumption-Based Asset Pricing with Higher Cumulants," NBER Working Papers 16153, National Bureau of Economic Research, Inc.
  5. Hanno Lustig & Nikolai Roussanov & Adrien Verdelhan, 2008. "Common Risk Factors in Currency Markets," NBER Working Papers 14082, National Bureau of Economic Research, Inc.
  6. Richard H. Clarida, 2007. "G7 Current Account Imbalances: Sustainability and Adjustment," NBER Books, National Bureau of Economic Research, Inc, number clar06-2, July.
  7. David Backus & Mikhail Chernov & Ian Martin, 2011. "Disasters Implied by Equity Index Options," Journal of Finance, American Finance Association, American Finance Association, vol. 66(6), pages 1969-2012, December.
  8. C. Emre Alper & Oya Pinar Ardic, 2010. "covered interest parity," The New Palgrave Dictionary of Economics, Palgrave Macmillan, Palgrave Macmillan.
  9. Markus K. Brunnermeier & Stefan Nagel & Lasse H. Pedersen, 2008. "Carry Trades and Currency Crashes," NBER Working Papers 14473, National Bureau of Economic Research, Inc.
  10. Adrien Verdelhan, 2006. "A Habit-Based Explanation of the Exchange Rate Risk Premium," Computing in Economics and Finance 2006, Society for Computational Economics 217, Society for Computational Economics.
  11. David K. Backus & Federico Gavazzoni & Christopher Telmer & Stanley E. Zin, 2010. "Monetary Policy and the Uncovered Interest Parity Puzzle," NBER Working Papers 16218, National Bureau of Economic Research, Inc.
  12. Barro, Robert, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," Scholarly Articles 3208215, Harvard University Department of Economics.
  13. Bansal, Ravi & Lehmann, Bruce N., 1997. "Growth-Optimal Portfolio Restrictions On Asset Pricing Models," Macroeconomic Dynamics, Cambridge University Press, Cambridge University Press, vol. 1(02), pages 333-354, June.
  14. Tarek Alexander Hassan, 2012. "Country Size, Currency Unions, and International Asset Returns," NBER Working Papers 18057, National Bureau of Economic Research, Inc.
  15. Athey, Susan, 2002. "Monotone Comparative Statics Under Uncertainty," Scholarly Articles 3372263, Harvard University Department of Economics.
  16. Riccardo Colacito & Mariano Croce, 2005. "Risks For The Long Run And The Real Exchange Rate," 2005 Meeting Papers, Society for Economic Dynamics 794, Society for Economic Dynamics.
  17. Ian Martin, 2011. "Simple Variance Swaps," NBER Working Papers 16884, National Bureau of Economic Research, Inc.
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Cited by:
  1. Matteo Maggiori, 2012. "Financial Intermediation, International Risk Sharing, and Reserve Currencies," 2012 Meeting Papers, Society for Economic Dynamics 146, Society for Economic Dynamics.
  2. Robert Ready & Nikolai Roussanov & Colin Ward, 2013. "Commodity Trade and the Carry Trade: a Tale of Two Countries," NBER Working Papers 19371, National Bureau of Economic Research, Inc.
  3. Katrin Rabitsch, 2014. "An Incomplete Markets Explanation to the UIP Puzzle," Department of Economics Working Papers wuwp171, Vienna University of Economics, Department of Economics.
  4. Andreas Stathopoulos & Andrea Vedolin & Philippe Mueller, 2012. "International Correlation Risk," 2012 Meeting Papers, Society for Economic Dynamics 818, Society for Economic Dynamics.

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