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Understanding the Forward Premium Puzzle: A Microstructure Approach

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Author Info
Burnside, A Craig
Eichenbaum, Martin
Rebelo, Sérgio

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Abstract

High-interest-rate currencies tend to appreciate relative to low-interest-rate currencies. We argue that adverse-selection problems between participants in foreign exchange markets can account for this `forward premium puzzle.' The key feature of our model is that the adverse selection problem facing market makers is worse when, based on public information, a currency is expected to appreciate.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 6399.

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Date of creation: Jul 2007
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Handle: RePEc:cpr:ceprdp:6399

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Related research
Keywords: Exchange rates; microstructure; Uncovered interest parity;

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

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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.:
  1. Giancarlo Corsetti & Amil Dasgupta & Stephen Morris & Hyun Song Shin, 2004. "Does One Soros Make a Difference? A Theory of Currency Crises with Large and Small Traders," Review of Economic Studies, Blackwell Publishing, vol. 71(1), pages 87-113, 01. [Downloadable!] (restricted)
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  2. Rui Albuquerque & Gregory H. Bauer & Martin Schneider, 2007. "International Equity Flows and Returns: A Quantitative Equilibrium Approach," Review of Economic Studies, Blackwell Publishing, vol. 74(1), pages 1-30, 01. [Downloadable!] (restricted)
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  3. Michael J. Fleming, 1997. "The round-the-clock market for U.S. Treasury securities," Economic Policy Review, Federal Reserve Bank of New York, issue Jul, pages 9-32. [Downloadable!]
  4. Philippe Bacchetta & Eric van Wincoop, 2006. "Incomplete information processing: a solution to the forward discount puzzle," Working Paper Series 2006-35, Federal Reserve Bank of San Francisco. [Downloadable!]
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  5. Massa, Massimo & Simonov, Andrei, 2003. "Reputation and interdealer trading: a microstructure analysis of the Treasury Bond market," Journal of Financial Markets, Elsevier, vol. 6(2), pages 99-141, April. [Downloadable!] (restricted)
  6. Bansal, Ravi & Dahlquist, Magnus, 2000. "The forward premium puzzle: different tales from developed and emerging economies," Journal of International Economics, Elsevier, vol. 51(1), pages 115-144, June. [Downloadable!] (restricted)
  7. Glosten, Lawrence R. & Milgrom, Paul R., 1985. "Bid, ask and transaction prices in a specialist market with heterogeneously informed traders," Journal of Financial Economics, Elsevier, vol. 14(1), pages 71-100, March. [Downloadable!] (restricted)
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  8. Albuquerque, Rui & de Francisco, Eva & Marques, Luis, 2006. "Marketwide Private Information in Stocks: Forecasting Currency Returns," CEPR Discussion Papers 5604, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  9. Charles Engel, 1996. "The Forward Discount Anomaly and the Risk Premium: A Survey of Recent Evidence," NBER Working Papers 5312, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  10. Han, Bing & Hirshleifer, David & Wang, Tracy Yue, 2005. "Investor Overconfidence and the Forward Discount Puzzle," Working Paper Series 2005-21, Ohio State University, Charles A. Dice Center for Research in Financial Economics. [Downloadable!]
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  11. Hansen, Lars Peter & Singleton, Kenneth J, 1982. "Generalized Instrumental Variables Estimation of Nonlinear Rational Expectations Models," Econometrica, Econometric Society, vol. 50(5), pages 1269-86, September. [Downloadable!] (restricted)
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Cited by:
(explanations, 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.)

  1. Burnside, A Craig & Eichenbaum, Martin & Kleshchelski, Isaac & Rebelo, Sérgio, 2006. "The Returns to Currency Speculation," CEPR Discussion Papers 5883, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  2. Hanno Lustig & Adrien Verdelhan, 2008. "Note on The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk," NBER Working Papers 13812, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  3. Markus K. Brunnermeier & Stefan Nagel & Lasse H. Pedersen, 2008. "Carry Trades and Currency Crashes," NBER Working Papers 14473, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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