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The Forward Premium Puzzle in a Model of Imperfect Information: Theory and Evidence

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Author Info
Rui Albuquerque (Simon School of Business, University of Rochester)

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Abstract

This paper studies the forward premium puzzle in an environment where private agents do not perfectly observe the shocks that drive monetary policy. Private agents optimally update their conditional expectations by means of the Kalman filter. The transition dynamics associated with Kalman filtering lead to fixed time-effects and conditional heteroskedasticity in the forward premium regression. I provide evidence for the presence of time-effects in the forward premium regression and find that the forward premium puzzle is significantly weakened. In particular, a 1 percent increase in the 1-month interest differential is expected to be accompanied by an additional 0.34 percent depreciation of the currency in the following month.

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Paper provided by EconWPA in its series International Finance with number 0405007.

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Date of creation: 06 May 2004
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Handle: RePEc:wpa:wuwpif:0405007

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Related research
Keywords: Forward premium puzzle; imperfect information; Kalman filter; fixed time-effects;

Find related papers by JEL classification:
F31 - International Economics - - International Finance - - - Foreign Exchange

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References listed on IDEAS
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