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European and Non-European Emerging Market Currencies: Forward Premium Puzzle and Fundamentals

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Abstract

The empirical literature has consistently rejected that the uncovered interest parity (UIP) theorem holds in practice, thus posing the well-known forward premium puzzle. In this study, we examine this issue for a sample of 18 emerging market currencies and, in addition, for a subsample of 6 currencies from emerging Europe. We first confirm earlier evidence for the existence of a forward premium puzzle for emerging market economies. We then extend the model with a view to exploring systematic relationships between excess returns from investments in foreign currency and country-specific economic fundamentals. Subsequently, we use this extended model to generate out-of-sample forecasts of currency returns. We also test for forecast accuracy, confirming that these forecasts are superior to naïve forecasts. Our results show that investments based on these forecasts generate considerably higher returns than alternative investment strategies. This applies in particular to our full sample of 18 emerging market currencies. For the subsample of 6 currencies from emerging Europe, profits per trade for the model-based forecasts also outperform those generated by the other investment strategies, but by a smaller margin. These results suggest that, compared with currencies of advanced countries, the smaller bias in the forward exchange rates of emerging market currencies found in the empirical literature could relate to the better predictability of currency returns for emerging market currencies.

Suggested Citation

  • Peter Backé & Franz Schardax, 2009. "European and Non-European Emerging Market Currencies: Forward Premium Puzzle and Fundamentals," Focus on European Economic Integration, Oesterreichische Nationalbank (Austrian Central Bank), issue 2, pages 56-66.
  • Handle: RePEc:onb:oenbfi:y:2009:i:2:b:1
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    File URL: https://www.oenb.at/dam/jcr:24c5203f-616b-4ee1-a038-ba030616679d/feei_2009_q2_backe_tcm16-137027.pdf
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    References listed on IDEAS

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    1. Balazs Egert & Carol Leonard, 2008. "Dutch Disease Scare in Kazakhstan: Is it real?," Open Economies Review, Springer, pages 147-165.
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    Cited by:

    1. Alexandra Horobet & Sorin Dumitrescu & Dan Gabriel Dumitrescu, 2009. "Uncovered Interest Parity and Financial Market Volatility," Romanian Economic Journal, Department of International Business and Economics from the Academy of Economic Studies Bucharest, vol. 12(32), pages 21-45, (2).

    More about this item

    Keywords

    Forward bias; emerging market currencies; forecasting;

    JEL classification:

    • F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation: Models and Applications
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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