Forward and Spot Exchange Rates in a Multi-Currency World
Tarek A. Hassan
University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)
Rui C. Mano
International Monetary Fund
April 6, 2015
Fama-Miller Working Paper
Chicago Booth Research Paper No. 15-02
Separate literatures study violations of uncovered interest parity using regression-based and portfolio-based methods. We propose a decomposition of these violations into a cross-currency, a between-time-and-currency, and a cross-time component that allows us to analytically relate regression-based and portfolio-based anomalies, to test whether they are empirically distinct, and to estimate the joint restrictions they place on models of currency returns. We find that the forward premium puzzle (FPP) and the "dollar trade'' anomaly are intimately linked. Both anomalies are almost exclusively driven by the cross-time component. By contrast, the ``carry trade'' anomaly is driven largely by the cross-currency component. Our decomposition also reveals a large upward bias in standard quantifications of the FPP. Once we correct for this bias, the puzzle is significantly diminished --- to the point that it does not require a systematic association between currency risk premia and expected depreciations. The simplest model that the data do not reject features a highly persistent asymmetry that makes some currencies pay higher expected returns than others, and a more elastic expected return on the US dollar than on other currencies.
Number of Pages in PDF File: 68
Keywords: Carry Trade, Forward Premium Puzzle, Uncovered Interest Parity
JEL Classification: F31, G12, G15
Date posted: June 2, 2013 ; Last revised: April 7, 2015
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