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
University of Chicago
May 31, 2013
Fama-Miller Working Paper
We decompose the covariance of currency returns with forward premia into a cross-currency, a between-time-and-currency, and a cross-time component. The surprising result of our decomposition is that the cross-currency and cross-time-components account for almost all systematic variation in expected currency returns, while the between-time-and-currency component is statistically and economically insignificant. This finding has three surprising implications for models of currency risk premia. First, it shows that the two most famous anomalies in international currency markets, the carry trade and the Forward Premium Puzzle (FPP), are separate phenomena that may require separate explanations. The carry trade is driven by persistent differences in currency risk premia across countries, while the FPP appears to be driven primarily by time-series variation in all currency risk premia against the US dollar. Second, it shows that both the carry trade and the FPP are puzzles about asymmetries in the risk characteristics of countries. The carry trade results from persistent differences in the risk characteristics of individual countries; the FPP is best explained by time variation in the average return of all currencies against the US dollar. As a result, existing models in which two symmetric countries interact in financial markets cannot explain either of the two anomalies.
Number of Pages in PDF File: 31
Keywords: Carry Trade, Forward Premium Puzzle, Uncovered Interest Parity
JEL Classification: F31, G12, E36working papers series
Date posted: June 2, 2013
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