The Forward Premium Puzzle in a Model of Imperfect Information: Theory and Evidence
Rui A. Albuquerque
Boston University - School of Management; Católica-Lisbon School of Business and Economics; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)
Simon School of Business Working Paper No. FR 00-09
This paper studies the forward premium puzzle in an environment where private agents do not perfectly observe the shocks that drive monetary policy. Private agents optimally update their conditional expectations by means of the Kalman filter. The transition dynamics associated with Kalman filtering lead to fixed time-effects and conditional heteroskedasticity in the forward premium regression. We provide evidence for some of the theoretical properties of the model and find that our empirical specification significantly weakens the forward premium puzzle. In particular, a 1 percent increase in the 1-month interest differential is expected to be accompanied by an additional 0.34 percent depreciation of the currency in the following month.
Number of Pages in PDF File: 29
JEL Classification: F31working papers series
Date posted: August 31, 1998
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