IDEAS home Printed from https://ideas.repec.org/p/nbr/nberwo/17564.html
   My bibliography  Save this paper

The Forward Premium Puzzle in a Two-Country World

Author

Listed:
  • Ian Martin

Abstract

I explore the behavior of asset prices and the exchange rate in a two-country world. When the large country has bad news, the relative price of the small country's output declines. As a result, the small country's bonds are risky, and uncovered interest parity fails, with positive excess returns available to investors who borrow at the large country's interest rate and lend at the small country's interest rate. I use a diagrammatic approach to derive these and other results in a calibration-free way.

Suggested Citation

  • Ian Martin, 2011. "The Forward Premium Puzzle in a Two-Country World," NBER Working Papers 17564, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:17564 Note: AP EFG IFM
    as

    Download full text from publisher

    File URL: http://www.nber.org/papers/w17564.pdf
    Download Restriction: no

    References listed on IDEAS

    as
    1. Nicholas Economides & Ioannis Lianos, 2009. "The Quest for Appropriate Remedies in the Microsoft Antitrust EU Cases: A Comparative Appraisal," Working Papers 09-05, NET Institute, revised Aug 2009.
    2. Richard H. Clarida, 2007. "G7 Current Account Imbalances: Sustainability and Adjustment," NBER Books, National Bureau of Economic Research, Inc, number clar06-2, January.
    3. Craig Burnside & Martin Eichenbaum & Isaac Kleshchelski & Sergio Rebelo, 2011. "Do Peso Problems Explain the Returns to the Carry Trade?," Review of Financial Studies, Society for Financial Studies, vol. 24(3), pages 853-891.
    4. C. Emre Alper & Oya Pinar Ardic, 2010. "covered interest parity," The New Palgrave Dictionary of Economics, Palgrave Macmillan.
    5. David Backus & Mikhail Chernov & Ian Martin, 2011. "Disasters Implied by Equity Index Options," Journal of Finance, American Finance Association, vol. 66(6), pages 1969-2012, December.
    6. Jordà, Òscar & Taylor, Alan M., 2012. "The carry trade and fundamentals: Nothing to fear but FEER itself," Journal of International Economics, Elsevier, pages 74-90.
    7. Hanno Lustig & Nikolai Roussanov & Adrien Verdelhan, 0. "Common Risk Factors in Currency Markets," Review of Financial Studies, Society for Financial Studies, pages 3731-3777.
    8. Adrien Verdelhan, 2010. "A Habit-Based Explanation of the Exchange Rate Risk Premium," Journal of Finance, American Finance Association, vol. 65(1), pages 123-146, February.
    9. Susan Athey, 2002. "Monotone Comparative Statics under Uncertainty," The Quarterly Journal of Economics, Oxford University Press, vol. 117(1), pages 187-223.
    10. Ian Martin, 2013. "The Lucas Orchard," Econometrica, Econometric Society, vol. 81(1), pages 55-111, January.
    11. Ian Martin, 2011. "Simple Variance Swaps," NBER Working Papers 16884, National Bureau of Economic Research, Inc.
    12. Jordà, Òscar & Taylor, Alan M., 2012. "The carry trade and fundamentals: Nothing to fear but FEER itself," Journal of International Economics, Elsevier, pages 74-90.
    13. Robert J. Barro, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," The Quarterly Journal of Economics, Oxford University Press, vol. 121(3), pages 823-866.
    14. Riccardo Colacito & Mariano M. Croce, 2011. "Risks for the Long Run and the Real Exchange Rate," Journal of Political Economy, University of Chicago Press, vol. 119(1), pages 153-181.
    15. Tarek A. Hassan, 2013. "Country Size, Currency Unions, and International Asset Returns," Journal of Finance, American Finance Association, vol. 68(6), pages 2269-2308, December.
    16. Ian W. Martin, 2013. "Consumption-Based Asset Pricing with Higher Cumulants," Review of Economic Studies, Oxford University Press, vol. 80(2), pages 745-773.
    17. Vives, Xavier, 1990. "Nash equilibrium with strategic complementarities," Journal of Mathematical Economics, Elsevier, vol. 19(3), pages 305-321.
    18. Markus K. Brunnermeier & Stefan Nagel & Lasse H. Pedersen, 2009. "Carry Trades and Currency Crashes," NBER Chapters,in: NBER Macroeconomics Annual 2008, Volume 23, pages 313-347 National Bureau of Economic Research, Inc.
    19. Bansal, Ravi & Lehmann, Bruce N., 1997. "Growth-Optimal Portfolio Restrictions On Asset Pricing Models," Macroeconomic Dynamics, Cambridge University Press, vol. 1(02), pages 333-354, June.
    20. David K. Backus & Federico Gavazzoni & Christopher Telmer & Stanley E. Zin, 2010. "Monetary Policy and the Uncovered Interest Parity Puzzle," NBER Working Papers 16218, National Bureau of Economic Research, Inc.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Katrin Rabitsch, 2014. "An Incomplete Markets Explanation to the UIP Puzzle," Department of Economics Working Papers wuwp171, Vienna University of Economics and Business, Department of Economics.
    2. Philippe Mueller & Andreas Stathopoulos & Andrea Vedolin, "undated". "International Correlation Risk," FMG Discussion Papers dp716, Financial Markets Group.
    3. Hassan, Tarek A. & Mertens, Thomas M. & Zhang, Tony, 2016. "Not so disconnected: Exchange rates and the capital stock," Journal of International Economics, Elsevier, pages 43-57.
    4. Matteo Maggiori, 2017. "Financial Intermediation, International Risk Sharing, and Reserve Currencies," American Economic Review, American Economic Association, pages 3038-3071.
    5. Emmanuel Farhi & Gita Gopinath & Oleg Itskhoki, 2014. "Fiscal Devaluations," Review of Economic Studies, Oxford University Press, pages 725-760.
    6. Emmanuel Farhi & Xavier Gabaix, "undated". "Rare Disasters and Exchange Rates," Working Paper 71001, Harvard University OpenScholar.
    7. Weithing Zhang & Thomas Mertens & Tarek Hassan, 2014. "Currency Manipulation," 2014 Meeting Papers 401, Society for Economic Dynamics.
    8. Tarek A. Hassan & Rui C. Mano, 2014. "Forward and Spot Exchange Rates in a Multi-currency World," NBER Working Papers 20294, National Bureau of Economic Research, Inc.
    9. Rabitsch, Katrin, 2014. "An Incomplete Markets Explanation to the UIP Puzzle," Department of Economics Working Paper Series 4109, WU Vienna University of Economics and Business.
    10. Kremens, Lukas & Martin, Ian, 2017. "The Quanto Theory of Exchange Rates," CEPR Discussion Papers 11970, C.E.P.R. Discussion Papers.
    11. Ready, Robert & Roussanov, Nikolai & Ward, Colin, 2017. "After the tide: Commodity currencies and global trade," Journal of Monetary Economics, Elsevier, vol. 85(C), pages 69-86.
    12. Nikolai Roussanov & Robert Ready, 2012. "Commodity Trade and the Carry Trade: a Tale of Two Countries," 2012 Meeting Papers 817, Society for Economic Dynamics.

    More about this item

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:nbr:nberwo:17564. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (). General contact details of provider: http://edirc.repec.org/data/nberrus.html .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.