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The Forward Premium Puzzle Revisited

  • Guy Meredith
  • Yue Ma
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The forward premium is a notoriously poor predictor of exchange rate movements. This failure must reflect deviations from risk neutrality and/or rational expectations. In addition, a mechanism is needed that generates the appropriate correlation between the forward premium and shocks arising from risk premia or expectations errors. This paper extends McCallum (1994) to show how such a correlation can arise from the response of monetary policy to output and inflation, which are in turn affected by the exchange rate. The theoretical models considered all generate results that are consistent with the forward premium being a biased predictor of short-term exchange rate movements; the bias decreases, however, as the horizon of the exchange rate change lengthens. Another common feature of the models is that the true reduced-form equation for exchange rate changes contains variables other than the interest differential, providing a justification for "eclectic" relationships for forecasting exchange rates. The results, however, remain consistent with using uncovered interest parity as a building block for structural models.

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Paper provided by International Monetary Fund in its series IMF Working Papers with number 02/28.

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Length: 39
Date of creation: 01 Feb 2002
Date of revision:
Handle: RePEc:imf:imfwpa:02/28
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  1. Ma, Yue, 1992. "Policy Measurement for the Dynamic Linear Model with Expectations Variables: A Multiplier Approach," Computer Science in Economics & Management, Society for Computational Economics, vol. 5(4), pages 303-12, November.
  2. Tiff Macklem, R., 1991. "Forward exchange rates and risk premiums in artificial economies," Journal of International Money and Finance, Elsevier, vol. 10(3), pages 365-391, September.
  3. Bennett T. McCallum & Edward Nelson, 2000. "Nominal Income Targeting in an Open-Economy Optimizing Model," NBER Working Papers 6675, National Bureau of Economic Research, Inc.
  4. Bennett T. McCallum, 1992. "A Reconsideration of the Uncovered Interest Parity Relationship," NBER Working Papers 4113, National Bureau of Economic Research, Inc.
  5. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-11, July.
  6. Kaushik Mitra & James Bullard, . "Learning About Monetary Policy Rules," Discussion Papers 00/41, Department of Economics, University of York.
  7. Robert P. Flood & Andrew K. Rose, 1994. "Fixes: Of The Forward Discount Puzzle," NBER Working Papers 4928, National Bureau of Economic Research, Inc.
  8. Richard Clarida & Jordi Gali & Mark Gertler, 2001. "Optimal Monetary Policy in Closed versus Open Economies: An Integrated Approach," NBER Working Papers 8604, National Bureau of Economic Research, Inc.
  9. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  10. Nelson C. Mark & Yangru Wu, 1996. "Risk, Policy Rules, and Noise: Rethinking Deviations From Uncovered Interest Parity," Working Papers 014, Ohio State University, Department of Economics.
  11. Olivier Jeanne & Andrew K. Rose, 1999. "Noise Trading and Exchange Rate Regimes," NBER Working Papers 7104, National Bureau of Economic Research, Inc.
  12. Bennett T. McCallum, 1981. "On Non-Uniqueness in Rational Expectations Models: An Attempt at Perspective," NBER Working Papers 0684, National Bureau of Economic Research, Inc.
  13. Guy Meredith & Menzie D. Chinn, 1998. "Long-Horizon Uncovered Interest Rate Parity," NBER Working Papers 6797, National Bureau of Economic Research, Inc.
  14. Michael Bleaney & Douglas Laxton, 2003. "Real Interest Rates And Real Exchange Rates: Evidence From Indexed Bonds," Manchester School, University of Manchester, vol. 71(1), pages 65-77, January.
  15. Bansal, Ravi & Dahlquist, Magnus, 1999. "The Forward Premium Puzzle: Different Tales from Developed and Emerging Economies," CEPR Discussion Papers 2169, C.E.P.R. Discussion Papers.
  16. McCallum, Bennett T., 1998. "Solutions to linear rational expectations models: a compact exposition," Economics Letters, Elsevier, vol. 61(2), pages 143-147, November.
  17. Froot, Kenneth A & Thaler, Richard H, 1990. "Foreign Exchange," Journal of Economic Perspectives, American Economic Association, vol. 4(3), pages 179-92, Summer.
  18. Lewis, Karen K., 1995. "Puzzles in international financial markets," Handbook of International Economics, in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 37, pages 1913-1971 Elsevier.
  19. Baillie, Richard T. & Bollerslev, Tim, 2000. "The forward premium anomaly is not as bad as you think," Journal of International Money and Finance, Elsevier, vol. 19(4), pages 471-488, August.
  20. Alexius, Annika, 2001. "Uncovered Interest Parity Revisited," Review of International Economics, Wiley Blackwell, vol. 9(3), pages 505-17, August.
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