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Understanding the Forward Premium Puzzle: A Microstructure Approach

Author

Listed:
  • Craig Burnside
  • Martin Eichenbaum
  • Sergio Rebelo

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 an agent wants to trade against a public information signal. So, when based on public information, the currency is expected to appreciate, there is more adverse selection associated with a sell order than with a buy order. (JEL E43, F31, G15)

Suggested Citation

  • Craig Burnside & Martin Eichenbaum & Sergio Rebelo, 2009. "Understanding the Forward Premium Puzzle: A Microstructure Approach," American Economic Journal: Macroeconomics, American Economic Association, vol. 1(2), pages 127-154, July.
  • Handle: RePEc:aea:aejmac:v:1:y:2009:i:2:p:127-54
    Note: DOI: 10.1257/mac.1.2.127
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    References listed on IDEAS

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    1. Philippe Bacchetta & Eric Van Wincoop, 2006. "Incomplete information processing: a solution to the forward discount puzzle," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
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    9. Han, Bing & Hirshleifer, David & Wang, Tracy, 2005. "Investor Overconfidence and the Forward Discount Puzzle," MPRA Paper 6497, University Library of Munich, Germany, revised Dec 2007.
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    More about this item

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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