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The Forward Premium Puzzle in a Two-Country World

  • Ian Martin

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.

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File URL: http://www.nber.org/papers/w17564.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17564.

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Date of creation: Nov 2011
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Handle: RePEc:nbr:nberwo:17564
Note: AP EFG IFM
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  1. Adrien Verdelhan, 2005. "A Habit-Based Explanation of the Exchange Rate Risk Premium," Boston University - Department of Economics - Working Papers Series WP2005-032, Boston University - Department of Economics.
  2. Hanno Lustig & Nikolai Roussanov & Adrien Verdelhan, 0. "Common Risk Factors in Currency Markets," Review of Financial Studies, Society for Financial Studies, vol. 24(11), pages 3731-3777.
  3. 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.
  4. A. Craig Burnside & Martin S. Eichenbaum & Isaac Kleshchelski & Sergio Rebelo, 2008. "Do Peso Problems Explain the Returns to the Carry Trade?," NBER Working Papers 14054, National Bureau of Economic Research, Inc.
  5. Tarek A. Hassan, 2009. "Country Size, Currency Unions, and International Asset Returns," Working Papers 154, Oesterreichische Nationalbank (Austrian Central Bank).
  6. Richard H. Clarida, 2006. "G7 Current Account Imbalances: Sustainability and Adjustment," NBER Working Papers 12194, National Bureau of Economic Research, Inc.
  7. 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.
  8. Ian Martin, 2010. "Consumption-Based Asset Pricing with Higher Cumulants," NBER Working Papers 16153, National Bureau of Economic Research, Inc.
  9. Jordà, Òscar & Taylor, Alan M., 2009. "The Carry Trade and Fundamentals: Nothing to Fear But FEER Itself," CEPR Discussion Papers 7568, C.E.P.R. Discussion Papers.
  10. Riccardo Colacito & Mariano Croce, 2005. "Risks For The Long Run And The Real Exchange Rate," 2005 Meeting Papers 794, Society for Economic Dynamics.
  11. 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.
  12. C. Emre Alper & Oya Pinar Ardic, 2010. "covered interest parity," The New Palgrave Dictionary of Economics, Palgrave Macmillan.
  13. Barro, Robert, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," Scholarly Articles 3208215, Harvard University Department of Economics.
  14. Ian Martin, 2013. "The Lucas Orchard," Econometrica, Econometric Society, vol. 81(1), pages 55-111, 01.
  15. Ian Martin, 2011. "Simple Variance Swaps," NBER Working Papers 16884, National Bureau of Economic Research, Inc.
  16. 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.
  17. Athey, Susan, 2002. "Monotone Comparative Statics Under Uncertainty," Scholarly Articles 3372263, Harvard University Department of Economics.
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