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
August 2, 2014
Fama-Miller Working Paper
Chicago Booth Research Paper No. 15-02
We decompose violations of uncovered interest parity into a cross-currency, a between-time-and-currency, and a cross-time component. We show that most of the systematic violations are in the cross-currency dimension. By contrast, we find no statistically reliable evidence that currency risk premia respond to deviations of forward premia from their time- and currency-specific mean. These results imply that the forward premium puzzle (FPP) and the carry-trade anomaly are separate phenomena that may require separate explanations. The carry trade is driven by static differences in interest rates across currencies, whereas the FPP appears to be driven primarily by cross-time variation in all currency risk premia against the US dollar. Models that feature two symmetric countries thus cannot explain either of the two phenomena. Once we make the appropriate econometric adjustments we also cannot reject the hypothesis that the elasticity of risk premia with respect to forward premia in all three dimensions is smaller than one. As a result, currency risk premia need not be correlated with expected changes in exchange rates (currencies with high interest rates depreciate rather than appreciate).
Number of Pages in PDF File: 64
Keywords: Carry Trade, Forward Premium Puzzle, Uncovered Interest Parity
JEL Classification: F31, G12, G15
Date posted: June 2, 2013 ; Last revised: January 26, 2015
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