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The Forward Premium Puzzle in a Two-Country World

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  • Ian Martin

Abstract

I explore the behavior of asset prices and the exchange rate in a two-country world. When the large country has bad news, the relative price of the small country's output declines. As a result, the small country's bonds are risky, and uncovered interest parity fails, with positive excess returns available to investors who borrow at the large country's interest rate and lend at the small country's interest rate. I use a diagrammatic approach to derive these and other results in a calibration-free way.

Suggested Citation

  • Ian Martin, 2011. "The Forward Premium Puzzle in a Two-Country World," NBER Working Papers 17564, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:17564
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    Citations

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    Cited by:

    1. Mueller, Philippe & Stathopoulos, Andreas & Vedolin, Andrea, 2017. "International correlation risk," Journal of Financial Economics, Elsevier, vol. 126(2), pages 270-299.
    2. Malamud, Semyon & Schrimpf, Paul, 2018. "An Intermediation-Based Model of Exchange Rates," CEPR Discussion Papers 13182, C.E.P.R. Discussion Papers.
    3. Hassan, Tarek A. & Mertens, Thomas M. & Zhang, Tony, 2016. "Not so disconnected: Exchange rates and the capital stock," Journal of International Economics, Elsevier, vol. 99(S1), pages 43-57.
    4. Matteo Maggiori, 2017. "Financial Intermediation, International Risk Sharing, and Reserve Currencies," American Economic Review, American Economic Association, vol. 107(10), pages 3038-3071, October.
    5. Emmanuel Farhi & Xavier Gabaix, "undated". "Rare Disasters and Exchange Rates," Working Paper 71001, Harvard University OpenScholar.
    6. Bosi, Stefano & Fontaine, Patrice & Le Van, Cuong, 2021. "Long-run equilibrium in international assets and goods markets: Why is the law of one price required?," Journal of Economic Behavior & Organization, Elsevier, vol. 190(C), pages 891-904.
    7. Weithing Zhang & Thomas Mertens & Tarek Hassan, 2014. "Currency Manipulation," 2014 Meeting Papers 401, Society for Economic Dynamics.
    8. Rabitsch, Katrin, 2014. "An Incomplete Markets Explanation to the UIP Puzzle," Department of Economics Working Paper Series 171, WU Vienna University of Economics and Business.
    9. Robert Ready & Nikolai Roussanov & Colin Ward, 2017. "Commodity Trade and the Carry Trade: A Tale of Two Countries," Journal of Finance, American Finance Association, vol. 72(6), pages 2629-2684, December.
    10. Tarek A Hassan & Rui C Mano, 2019. "Forward and Spot Exchange Rates in a Multi-Currency World," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 134(1), pages 397-450.
    11. Tarek A Hassan & Thomas M Mertens & Tony Zhang, 2023. "A Risk-based Theory of Exchange Rate Stabilization," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 90(2), pages 879-911.
    12. Lukas Kremens & Ian Martin, 2019. "The Quanto Theory of Exchange Rates," American Economic Review, American Economic Association, vol. 109(3), pages 810-843, March.
    13. Antoine GODIN & Sakir-Devrim YILMAZ, 2020. "Modelling Small Open Developing Economies in a Financialized World: A Stock-Flow Consistent Prototype Growth Model," Working Paper 5eb7e0e8-560f-4ce6-91a5-5, Agence française de développement.
    14. Katrin Rabitsch, 2014. "An Incomplete Markets Explanation to the UIP Puzzle," Department of Economics Working Papers wuwp171, Vienna University of Economics and Business, Department of Economics.
    15. Christoph Meinerding, 2012. "Asset Allocation And Asset Pricing In The Face Of Systemic Risk: A Literature Overview And Assessment," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 15(03), pages 1-27.
    16. Ready, Robert & Roussanov, Nikolai & Ward, Colin, 2017. "After the tide: Commodity currencies and global trade," Journal of Monetary Economics, Elsevier, vol. 85(C), pages 69-86.
    17. Zhengyang Jiang, 2019. "US Fiscal Cycle and the Dollar," 2019 Meeting Papers 667, Society for Economic Dynamics.

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    More about this item

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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