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Affine Term Structure Models and the Forward Premium Anomaly

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  • David K. Backus
  • Silverio Foresi
  • Chris I. Telmer

Abstract

One of the most puzzling features of currency prices is the forward premium anomaly: the tendency for high interest rate currencies to appreciate. We characterize the anomaly in the context of affine models of the term structure of interest rates. In affine models, the anomaly requires either that state variables have asymmetric effects on state prices in different currencies or that nominal interest rates take on negative values with positive probability. We find the quantitative properties of either alternative to have important shortcomings.

Suggested Citation

  • David K. Backus & Silverio Foresi & Chris I. Telmer, 2001. "Affine Term Structure Models and the Forward Premium Anomaly," Journal of Finance, American Finance Association, vol. 56(1), pages 279-304, February.
  • Handle: RePEc:bla:jfinan:v:56:y:2001:i:1:p:279-304
    DOI: 10.1111/0022-1082.00325
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    File URL: https://doi.org/10.1111/0022-1082.00325
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