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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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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
Date of revision:
Handle: RePEc:nbr:nberwo:17564
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  1. Adrien Verdelhan, 2006. "A Habit-Based Explanation of the Exchange Rate Risk Premium," Computing in Economics and Finance 2006 217, Society for Computational Economics.
  2. Vives, Xavier, 1990. "Nash equilibrium with strategic complementarities," Journal of Mathematical Economics, Elsevier, vol. 19(3), pages 305-321.
  3. Burnside, Craig & Eichenbaum, Martin & Kleshchelski, Isaac & Rebelo, Sérgio, 2008. "Do Peso Problems Explain the Returns to the Carry Trade?," CEPR Discussion Papers 6873, C.E.P.R. Discussion Papers.
  4. 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.
  5. Hanno Lustig & Nikolai Roussanov & Adrien Verdelhan, 2008. "Common Risk Factors in Currency Markets," NBER Working Papers 14082, National Bureau of Economic Research, Inc.
  6. Richard H. Clarida, 2007. "G7 Current Account Imbalances: Sustainability and Adjustment," NBER Books, National Bureau of Economic Research, Inc, number clar06-2, July.
  7. 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.
  8. Hassan, Tarek, 2012. "Country Size, Currency Unions, and International Asset Returns," CEPR Discussion Papers 8991, C.E.P.R. Discussion Papers.
  9. Ian Martin, 2011. "The Lucas Orchard," NBER Working Papers 17563, National Bureau of Economic Research, Inc.
  10. Athey, Susan, 2002. "Monotone Comparative Statics Under Uncertainty," Scholarly Articles 3372263, Harvard University Department of Economics.
  11. Riccardo Colacito & Mariano Croce, 2005. "Risks For The Long Run And The Real Exchange Rate," 2005 Meeting Papers 794, Society for Economic Dynamics.
  12. David Backus & Mikhail Chernov & Ian Martin, 2009. "Disasters implied by equity index options," NBER Working Papers 15240, National Bureau of Economic Research, Inc.
  13. Markus K. Brunnermeier & Stefan Nagel & Lasse H. Pedersen, 2008. "Carry Trades and Currency Crashes," NBER Working Papers 14473, National Bureau of Economic Research, Inc.
  14. Ian Martin, 2010. "Consumption-Based Asset Pricing with Higher Cumulants," NBER Working Papers 16153, National Bureau of Economic Research, Inc.
  15. 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.
  16. Barro, Robert, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," Scholarly Articles 3208215, Harvard University Department of Economics.
  17. C. Emre Alper & Oya Pinar Ardic, 2010. "covered interest parity," The New Palgrave Dictionary of Economics, Palgrave Macmillan.
  18. Ian Martin, 2011. "Simple Variance Swaps," NBER Working Papers 16884, National Bureau of Economic Research, Inc.
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