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Forward premium puzzle and term structure of interest rates: the case of New Zealand

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  • Carmen Gloria Silva

Abstract

Using monthly data for the United States dollar – New Zealand dollar exchange rate, this paper revisits the forward premium puzzle and applies a discrete no-arbitrage affine model of the term structure of interest rates to obtain historical estimates of the time-varying foreign exchange risk premium. The two-factor model is estimated via maximum likelihood for the period 1995-2006. The results of this study demonstrate that the modeled risk premium satisfies the required Fama’s conditions, and its inclusion in an extended GARCH(1,1) model is significant in explaining both the mean and the volatility of the exchange rate. However, consistently with the extant literature, the estimated risk premium does not preclude the presence of the forward premium anomaly. Lastly, out-of-sample forecasts of the exchange rate for different specifications and time periods reveal that predictions of the proposed model for the exchange rate are far from the accuracy of a simple random walk specification.

Suggested Citation

  • Carmen Gloria Silva, 2010. "Forward premium puzzle and term structure of interest rates: the case of New Zealand," Working Papers Central Bank of Chile 570, Central Bank of Chile.
    • Handle: RePEc:chb:bcchwp:570
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    File URL: https://www.bcentral.cl/documents/33528/133326/DTBC_570.pdf
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    Cited by:

    1. Michael B. Devereux, 2011. "Fiscal Deficits, Debt, and Monetary Policy in a Liquidity Trap," Central Banking, Analysis, and Economic Policies Book Series, in: Luis Felipe Céspedes & Roberto Chang & Diego Saravia (ed.),Monetary Policy under Financial Turbulence, edition 1, volume 16, chapter 10, pages 369-410, Central Bank of Chile.
    2. Miguel Ricaurte, 2010. "The Role of Labor Markets in Structural Change," Working Papers Central Bank of Chile 584, Central Bank of Chile.
    3. Eric M. Leeper, 2009. "Anchors Away: How Fiscal Policy Can Undermine “Good” Monetary Policy," CAEPR Working Papers 2009-021, Center for Applied Economics and Policy Research, Department of Economics, Indiana University Bloomington.

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