Econometrics of the forward premium puzzle
This paper explores from a new perspective the forward premium puzzle, i.e., why a regression of the change in the future spot exchange rate on the forward premium paradoxically yields a coefficient that is frequently negative. This traditional specification is compared theoretically and empirically to a "level" regression of the future spot rate on the current forward rate, which does not display the puzzle. We explore both non-rationality and risk premium explanations. The general conclusion is that, with non-rationality, any modest deviation from unity in the level coefficient becomes greatly magnified in the forward premium coefficient because of the stationary/nonstationary properties of the relevant variables, thereby generating the puzzle.
|Date of creation:||15 Oct 2005|
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