IDEAS home Printed from
   My bibliography  Save this paper

Learning, the Forward Premium Puzzle and Market Efficiency


  • Avik Chakraborty

    () (University of Oregon - Student)


The Forward Premium Puzzle is one of the most prominent empirical anomalies in international finance. The forward premium predicts exchange rate depreciation but typically with the opposite sign and smaller magnitude than specified by rational expectations, a result also considered to indicate inefficiency in the foreign exchange market. This paper proposes a resolution of the puzzle based on recursive least squares learning applied to a simple model of exchange rate determination. The key assumption is that risk neutral agents are not blessed with rational expectations and do not have perfect knowledge about the market. Agents learn about the parameters underlying the stochastic process generating the exchange rate using constant gain recursive least squares. When exchange rate data are generated from the model and the empirical tests are performed, for plausible parameter values the results replicate the anomaly along with other observed empirical features of the forward and spot exchange rate data.

Suggested Citation

  • Avik Chakraborty, 2004. "Learning, the Forward Premium Puzzle and Market Efficiency," University of Oregon Economics Department Working Papers 2005-4, University of Oregon Economics Department, revised 01 Oct 2004.
  • Handle: RePEc:ore:uoecwp:2005-4

    Download full text from publisher

    File URL:
    Download Restriction: no

    References listed on IDEAS

    1. William Branch & George W. Evans, 2007. "Model Uncertainty and Endogenous Volatility," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 10(2), pages 207-237, April.
    2. George W. Evans & Seppo Honkapohja, 2005. "Policy Interaction, Expectations and the Liquidity Trap," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 8(2), pages 303-323, April.
    3. Thomas Doan & Robert B. Litterman & Christopher A. Sims, 1983. "Forecasting and Conditional Projection Using Realistic Prior Distributions," NBER Working Papers 1202, National Bureau of Economic Research, Inc.
    4. Kenneth Kasa, 2004. "Learning, Large Deviations, And Recurrent Currency Crises," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 45(1), pages 141-173, February.
    5. William Poole & Robert H. Rasche, 2002. "Flation," Review, Federal Reserve Bank of St. Louis, issue Nov, pages 1-6.
      • William Poole, 2002. "Flation," Speech 49, Federal Reserve Bank of St. Louis.
    6. Cho, In-Koo & Kasa, Kenneth, 2008. "Learning Dynamics And Endogenous Currency Crises," Macroeconomic Dynamics, Cambridge University Press, vol. 12(02), pages 257-285, April.
    7. Stark, Tom & Croushore, Dean, 2002. "Forecasting with a real-time data set for macroeconomists," Journal of Macroeconomics, Elsevier, vol. 24(4), pages 507-531, December.
    8. In-Koo Cho & Noah Williams & Thomas J. Sargent, 2002. "Escaping Nash Inflation," Review of Economic Studies, Oxford University Press, vol. 69(1), pages 1-40.
    9. Andrew C. Harvey, 1990. "The Econometric Analysis of Time Series, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 026208189x, July.
    10. Stark, Tom & Croushore, Dean, 2002. "Reply to the comments on 'Forecasting with a real-time data set for macroeconomists'," Journal of Macroeconomics, Elsevier, vol. 24(4), pages 563-567, December.
    11. Milani, Fabio, 2007. "Expectations, learning and macroeconomic persistence," Journal of Monetary Economics, Elsevier, vol. 54(7), pages 2065-2082, October.
    12. Pesaran, M Hashem & Timmermann, Allan, 1995. " Predictability of Stock Returns: Robustness and Economic Significance," Journal of Finance, American Finance Association, vol. 50(4), pages 1201-1228, September.
    13. Stock, James H & Watson, Mark W, 1996. "Evidence on Structural Instability in Macroeconomic Time Series Relations," Journal of Business & Economic Statistics, American Statistical Association, vol. 14(1), pages 11-30, January.
    14. James B. Bullard & John Duffy, 2004. "Learning and structural change in macroeconomic data," Working Papers 2004-016, Federal Reserve Bank of St. Louis.
    Full references (including those not matched with items on IDEAS)


    Blog mentions

    As found by, the blog aggregator for Economics research:
    1. In praise of belief in efficient markets
      by chris dillow in Stumbling and Mumbling on 2009-02-13 17:14:47


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

    Cited by:

    1. Lewis Vivien & Markiewicz Agnieszka, 2009. "Model Misspecification, Learning and the Exchange Rate Disconnect Puzzle," The B.E. Journal of Macroeconomics, De Gruyter, vol. 9(1), pages 1-24, April.
    2. Brian Lucey & Grace Loring, 2012. "Forward Exchange Rate Biasedness across Developed and Developing Country Currencies - Do Observed Patterns Persist Out of Sample?Abstract:," The Institute for International Integration Studies Discussion Paper Series iiisdp404, IIIS.

    More about this item


    Spot Exchange Rate; Forward Rate; Constant-gain Recursive Least Squares Learning.;

    NEP fields

    This paper has been announced in the following NEP Reports:


    Access and download statistics


    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:ore:uoecwp:2005-4. 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: (Bill Harbaugh). General contact details of provider: .

    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.

    We have no references for this item. You can help adding them by using 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.