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

Author

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  • Rui Albuquerque

    (Simon School of Business, University of Rochester)

Abstract

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.

Suggested Citation

  • Rui Albuquerque, 2004. "The Forward Premium Puzzle in a Model of Imperfect Information: Theory and Evidence," International Finance 0405007, University Library of Munich, Germany.
  • Handle: RePEc:wpa:wuwpif:0405007
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Forward premium puzzle; imperfect information; Kalman filter; fixed time-effects;

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange

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