IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Login to save this paper or follow this series

The Forward Premium Puzzle in a Model of Imperfect Information: Theory and Evidence

  • Rui Albuquerque

    (Simon School of Business, University of Rochester)

This paper studies the forward premium puzzle in an environment where private agents do not perfectly observe the shocks that drive monetary policy. Private agents optimally update their conditional expectations by means of the Kalman filter. The transition dynamics associated with Kalman filtering lead to fixed time-effects and conditional heteroskedasticity in the forward premium regression. I provide evidence for the presence of time-effects in the forward premium regression and find that the forward premium puzzle is significantly weakened. In particular, a 1 percent increase in the 1-month interest differential is expected to be accompanied by an additional 0.34 percent depreciation of the currency in the following month.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL: http://econwpa.repec.org/eps/if/papers/0405/0405007.pdf
Download Restriction: no

Paper provided by EconWPA in its series International Finance with number 0405007.

as
in new window

Length:
Date of creation: 06 May 2004
Date of revision:
Handle: RePEc:wpa:wuwpif:0405007
Note: Type of Document - pdf
Contact details of provider: Web page: http://econwpa.repec.org

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

as in new window
  1. 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.
  2. Geert Bekaert & Robert J. Hodrick, 1991. "On Biases in the Measurement of Foreign Exchange Risk Premiums," NBER Working Papers 3861, National Bureau of Economic Research, Inc.
  3. Robert E. Cumby & Maurice Obstfeld, 1982. "International Interest-Rate and Price-Level Linkages Under Flexible Exchange Rates: A Review of Recent Evidence," NBER Working Papers 0921, National Bureau of Economic Research, Inc.
  4. Lewis, Karen K., 1988. "The persistence of the `peso problem' when policy is noisy," Journal of International Money and Finance, Elsevier, vol. 7(1), pages 5-21, March.
  5. Geert Bekaert & Robert J. Hodrick & David A. Marshall, 1994. "The implications of first-order risk aversion for asset market risk premiums," Working Paper Series, Macroeconomic Issues 94-22, Federal Reserve Bank of Chicago.
  6. Gourinchas, Pierre-Olivier & Tornell, Aaron, 2004. "Exchange rate puzzles and distorted beliefs," Journal of International Economics, Elsevier, vol. 64(2), pages 303-333, December.
  7. Robert P. Flood & Andrew K. Rose, 1994. "Fixes: Of The Forward Discount Puzzle," NBER Working Papers 4928, National Bureau of Economic Research, Inc.
  8. Robert J. Hodrick & Sanjay Srivastava, 1983. "An Investigation of Risk and Return in Forward Foreign Exchange," NBER Working Papers 1180, National Bureau of Economic Research, Inc.
  9. Froot, Kenneth A & Frankel, Jeffrey A, 1989. "Forward Discount Bias: Is It an Exchange Risk Premium?," The Quarterly Journal of Economics, MIT Press, vol. 104(1), pages 139-61, February.
  10. David Backus & Silverio Foresi & Chris Telmer, 1996. "Affine Models of Currency Pricing," NBER Working Papers 5623, National Bureau of Economic Research, Inc.
  11. E. Scott Mayfield & Robert G. Murphy, 1993. "Interest Rate Parity And The Exchange Risk Premium: Evidence From Panel Data," Boston College Working Papers in Economics 239, Boston College Department of Economics.
  12. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 1998. "Modeling Money," NBER Working Papers 6371, National Bureau of Economic Research, Inc.
  13. Korajczyk, Robert A, 1985. "The Pricing of Forward Contracts for Foreign Exchange," Journal of Political Economy, University of Chicago Press, vol. 93(2), pages 346-68, April.
  14. Maurice Obstfeld, 1987. "Peso Problems, Bubbles, and Risk in the Empirical Assessment of Exchange-Rate Behavior," NBER Working Papers 2203, National Bureau of Economic Research, Inc.
  15. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 1998. "Monetary Policy Shocks: What Have We Learned and to What End?," NBER Working Papers 6400, National Bureau of Economic Research, Inc.
  16. Newey, Whitney & West, Kenneth, 2014. "A simple, positive semi-definite, heteroscedasticity and autocorrelation consistent covariance matrix," Applied Econometrics, Publishing House "SINERGIA PRESS", vol. 33(1), pages 125-132.
  17. Froot, Kenneth A & Thaler, Richard H, 1990. "Foreign Exchange," Journal of Economic Perspectives, American Economic Association, vol. 4(3), pages 179-92, Summer.
  18. Telmer, Chris I, 1993. " Asset-Pricing Puzzles and Incomplete Markets," Journal of Finance, American Finance Association, vol. 48(5), pages 1803-32, December.
  19. Bekaert, Geert, 1994. "Exchange rate volatility and deviations from unbiasedness in a cash-in-advance model," Journal of International Economics, Elsevier, vol. 36(1-2), pages 29-52, February.
  20. Bennett T. McCallum, 1992. "A Reconsideration of the Uncovered Interest Parity Relationship," NBER Working Papers 4113, National Bureau of Economic Research, Inc.
  21. Robert J. Hodrick, 1987. "Risk, Uncertainty and Exchange Rates," NBER Working Papers 2429, National Bureau of Economic Research, Inc.
  22. Canova, Fabio & Marrinan, Jane, 1993. "Profits, risk, and uncertainty in foreign exchange markets," Journal of Monetary Economics, Elsevier, vol. 32(2), pages 259-286, November.
  23. Lothian, James R. & Wu, Liuren, 2011. "Uncovered interest-rate parity over the past two centuries," Journal of International Money and Finance, Elsevier, vol. 30(3), pages 448-473, April.
  24. Bachman, Daniel, 1992. "The effect of political risk on the forward exchange bias: the case of elections," Journal of International Money and Finance, Elsevier, vol. 11(2), pages 208-219, April.
  25. Lucas, Robert Jr., 1982. "Interest rates and currency prices in a two-country world," Journal of Monetary Economics, Elsevier, vol. 10(3), pages 335-359.
  26. Eric M. Leeper & Christopher A. Sims & Tao Zha, 1996. "What Does Monetary Policy Do?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 27(2), pages 1-78.
  27. Domowitz, Ian & Hakkio, Craig S., 1985. "Conditional variance and the risk premium in the foreign exchange market," Journal of International Economics, Elsevier, vol. 19(1-2), pages 47-66, August.
  28. Marston, Richard C., 1997. "Tests of three parity conditions: Distinguishing risk premia and systematic forecast errors," Journal of International Money and Finance, Elsevier, vol. 16(2), pages 285-303, April.
  29. Stulz, Rene M, 1987. "An Equilibrium Model of Exchange Rate Determination and Asset Pricing with Nontraded Goods and Imperfect Information," Journal of Political Economy, University of Chicago Press, vol. 95(5), pages 1024-40, October.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:wpa:wuwpif:0405007. 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: (EconWPA)

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.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with 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 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.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.