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Econometrics of the forward premium puzzle

Author

Listed:
  • Stephen E. Haynes
  • Avik Chakraborty

    (Department of Economics, University of Tennessee)

Abstract

This paper explores from a new perspective the forward premium puzzle, i.e., why a regression of the change in the future spot exchange rate on the forward premium paradoxically yields a coefficient that is frequently negative. This traditional specification is compared theoretically and empirically to a "level" regression of the future spot rate on the current forward rate, which does not display the puzzle. We explore both non-rationality and risk premium explanations. The general conclusion is that, with non-rationality, any modest deviation from unity in the level coefficient becomes greatly magnified in the forward premium coefficient because of the stationary/nonstationary properties of the relevant variables, thereby generating the puzzle.

Suggested Citation

  • Stephen E. Haynes & Avik Chakraborty, 2005. "Econometrics of the forward premium puzzle," University of Oregon Economics Department Working Papers 2005-18, University of Oregon Economics Department.
    • Handle: RePEc:ore:uoecwp:2005-18
    as

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    File URL: http://economics.uoregon.edu/papers/UO-2005-18_Haynes_Forward.pdf
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    More about this item

    Keywords

    Forward premium puzzle; Spot and forward exchange rates; Foreign exchange market efficiency; Non-rationality in foreign exchange markets;
    All these keywords.

    JEL classification:

    • F30 - International Economics - - International Finance - - - General
    • F31 - International Economics - - International Finance - - - Foreign Exchange

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