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The Forward Puzzle: The Roles of Exchange Rate Regime and Base Currency Strength

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  • Fang Liu
  • Piet Sercu

Abstract

The forward puzzle is traditionally explained as the presence of a covariance‐risk premium, market friction or limits to arbitrage. Recently, Liu and Sercu, working on intra‐ERM rates for the DEM, presented evidence consistent with career risk considerations: portfolio managers shun assets with danger signals. In this paper, we test the external validity of this finding: we compare floating rates to band regimes, and strong base currencies to weak ones. We find that both the exchange rate regime and base currency strength influence the evidence on various theories: floating and strong intra‐ERM rates weakly support market friction or limit‐to‐arbitrage theories, while the HKD and weak intra‐ERM strongly support the career risk effect. We also decompose forward premium into a short‐term filtered component and a long memory trend. The filtered component is good at recognising danger signals or ‘extreme’ observation effects for band regime rates and weak floaters, while the trend works best for strong floaters. Lastly, the filtered premium provides the best fit, consistent with the idea that it has a closer link to expectations than the trend component.

Suggested Citation

  • Fang Liu & Piet Sercu, 2009. "The Forward Puzzle: The Roles of Exchange Rate Regime and Base Currency Strength," The World Economy, Wiley Blackwell, vol. 32(7), pages 1055-1074, July.
    • Handle: RePEc:bla:worlde:v:32:y:2009:i:7:p:1055-1074
    DOI: 10.1111/j.1467-9701.2009.01196.x
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    References listed on IDEAS

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    1. Backus, David K. & Smith, Gregor W., 1993. "Consumption and real exchange rates in dynamic economies with non-traded goods," Journal of International Economics, Elsevier, vol. 35(3-4), pages 297-316, November.
    2. Lucio Sarno & Giorgio Valente & Hyginus Leon, 2006. "Nonlinearity in Deviations from Uncovered Interest Parity: An Explanation of the Forward Bias Puzzle," Review of Finance, European Finance Association, vol. 10(3), pages 443-482, September.
    3. Richard Roll & Shu Yan, 2000. "An explanation of the forward premium ‘puzzle’," European Financial Management, European Financial Management Association, vol. 6(2), pages 121-148, June.
    4. Fang Liu & Piet Sercu, 2009. "The Forex Forward Puzzle: The Career Risk Hypothesis," The Financial Review, Eastern Finance Association, vol. 44(3), pages 371-404, August.
    5. Bansal, Ravi, 1997. "An Exploration of the Forward Premium Puzzle in Currency Markets," The Review of Financial Studies, Society for Financial Studies, vol. 10(2), pages 369-403.
    6. Huisman, Ronald & Koedijk, Kees & Kool, Clemens & Nissen, Francois, 1998. "Extreme support for uncovered interest parity," Journal of International Money and Finance, Elsevier, vol. 17(1), pages 211-228, February.
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    Cited by:

    1. 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, September.

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