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The Forward Discount Puzzle: Identi cation of Economic Assumptions

Author

Listed:
  • Seongman Moon

    () (Universidad Carlos III de Madrid)

  • Carlos Velasco

    () (Universidad Carlos III de Madrid)

Abstract

The forward discount puzzle refers to the robust empirical finding that foreign excess returns are predictable. We investigate if expectations errors are the main cause of this predictability using the serial dependence pattern of excess returns implied by economic models as identification device. This approach also allows us to explain why strong predictability of excess returns only occurs during 1980s. Using USD bilateral spot and forward rates from 1975-2009, we show that both the statistically significant positive serial dependence of excess returns in the entire sample and the very weak (mostly insignificant) positive serial dependence in the subsample excluding observations in 1980-87 are consistent with the predictions of the expectations errors explanation. We provide several pieces of new empirical evidence which support the link between the strong predictability in the 1980s and changes in forecasting techniques by foreign exchange market agents.

Suggested Citation

  • Seongman Moon & Carlos Velasco, 2011. "The Forward Discount Puzzle: Identi cation of Economic Assumptions," Working Papers 1112, Research Institute for Market Economy, Sogang University.
  • Handle: RePEc:sgo:wpaper:1112
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    References listed on IDEAS

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    Cited by:

    1. Michael Jetter & Alex Nikolsko-Rzhevskyy, 2013. "Monetary Policy Shifts and the Forward Discount Puzzle," DOCUMENTOS DE TRABAJO CIEF 010729, UNIVERSIDAD EAFIT.
    2. Moon, Seongman & Velasco, Carlos, 2013. "Tests for m-dependence based on sample splitting methods," Journal of Econometrics, Elsevier, vol. 173(2), pages 143-159.
    3. 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.
    4. Loring, Grace & Lucey, Brian, 2013. "An analysis of forward exchange rate biasedness across developed and developing country currencies: Do observed patterns persist out of sample?," Emerging Markets Review, Elsevier, vol. 17(C), pages 14-28.

    More about this item

    Keywords

    expectations errors; rational expectations risk premium; excess returns; serial dependence; 1980-87.;

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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