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The Forward Premium Puzzle And Risk Premiums

  • Nagayasu, Jun

This paper re-evaluates the forward premium puzzle using the Euro/US dollar exchange rate. Unlike previous studies, a state-space model is used to measure the significance of this puzzle by estimating the time-specific parameter. Then we provide evidence that the forward premium puzzle became more prominent around the time of the Lehman Shock, and this additional effect of the puzzle is more clearly seen in longer maturity assets. Furthermore, while the risk premium does not tell the whole story about the time-varying puzzle, we show nevertheless that the puzzle can be lessened by this extra factor particularly at times of financial crises.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 42472.

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Date of creation: 01 Sep 2012
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Handle: RePEc:pra:mprapa:42472
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  1. Frankel, Jeffrey & Poonawala, Jumana, 2010. "The forward market in emerging currencies: Less biased than in major currencies," Journal of International Money and Finance, Elsevier, vol. 29(3), pages 585-598, April.
  2. Tigran Poghosyan & Evzen Kocenda, 2007. "Macroeconomic Sources of Foreign Exchange Risk in New EU Members," William Davidson Institute Working Papers Series wp898, William Davidson Institute at the University of Michigan.
  3. Kenneth A. Froot & Jeffrey A. Frankel, 1989. "Forward Discount Bias: Is it an Exchange Risk Premium?," The Quarterly Journal of Economics, Oxford University Press, vol. 104(1), pages 139-161.
  4. Kim, Chang-Jin, 1994. "Dynamic linear models with Markov-switching," Journal of Econometrics, Elsevier, vol. 60(1-2), pages 1-22.
  5. Hanno Lustig & Adrien Verdelhan, 2007. "The Cross Section of Foreign Currency Risk Premia and Consumption Growth Risk," American Economic Review, American Economic Association, vol. 97(1), pages 89-117, March.
  6. Charles Engel, 1995. "The Forward Discount Anomaly and the Risk Premium: A Survey of Recent Evidence," NBER Working Papers 5312, National Bureau of Economic Research, Inc.
  7. Craig Burnside & Martin S. Eichenbaum & Sergio Rebelo, 2007. "Understanding the Forward Premium Puzzle: A Microstructure Approach," NBER Working Papers 13278, National Bureau of Economic Research, Inc.
  8. Philippe Bacchetta & Eric van Wincoop, 2010. "Infrequent Portfolio Decisions: A Solution to the Forward Discount Puzzle," American Economic Review, American Economic Association, vol. 100(3), pages 870-904, June.
  9. Evans, Martin D. & Lyons, Richard K., 1999. "Order Flow and Exchange Rate Dynamics," Research Program in Finance, Working Paper Series qt0dh1c16w, Research Program in Finance, Institute for Business and Economic Research, UC Berkeley.
  10. Niall Coffey & Warren B. Hrung & Asani Sarkar, 2009. "Capital constraints, counterparty risk, and deviations from covered interest rate parity," Staff Reports 393, Federal Reserve Bank of New York.
  11. Bruce E. Hansen, 1995. "Approximate Asymptotic P-Values for Structural Change Tests," Boston College Working Papers in Economics 297., Boston College Department of Economics.
  12. Jun Nagayasu, 2011. "The Common Component in Forward Premiums: Evidence from the Asia–Pacific Region," Review of International Economics, Wiley Blackwell, vol. 19(4), pages 750-762, 09.
  13. Menzie D. Chinn & Guy Meredith, 2004. "Monetary Policy and Long-Horizon Uncovered Interest Parity," IMF Staff Papers, Palgrave Macmillan, vol. 51(3), pages 409-430, November.
  14. Engle, Robert F & Lilien, David M & Robins, Russell P, 1987. "Estimating Time Varying Risk Premia in the Term Structure: The Arch-M Model," Econometrica, Econometric Society, vol. 55(2), pages 391-407, March.
  15. Byrne, Joseph P & Nagayasu, Jun, 2011. "Common factors of the exchange risk premium in emerging European markets," MPRA Paper 31393, University Library of Munich, Germany.
  16. Taylor, Mark P, 1989. "Covered Interest Arbitrage and Market Turbulence," Economic Journal, Royal Economic Society, vol. 99(396), pages 376-91, June.
  17. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
  18. Stephen Hall & P. A. V. B. Swamy & George S. Tavlas & Amangeldi Kenjegaliev, 2011. "The Forward Rate Premium Puzzle: A Resolution?," Discussion Papers in Economics 11/23, Department of Economics, University of Leicester.
  19. MacDonald, Ronald & Torrance, Thomas S, 1990. "Expectations Formation and Risk in Four Foreign Exchange Markets," Oxford Economic Papers, Oxford University Press, vol. 42(3), pages 544-61, July.
  20. Martin Eichenbaum & Charles L. Evans, 1995. "Some Empirical Evidence on the Effects of Shocks to Monetary Policy on Exchange Rates," The Quarterly Journal of Economics, Oxford University Press, vol. 110(4), pages 975-1009.
  21. Frankel, Jeffrey A, 1992. "Measuring International Capital Mobility: A Review," American Economic Review, American Economic Association, vol. 82(2), pages 197-202, May.
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