Understanding the Forward Premium Puzzle: A Microstructure Approach
31 Pages Posted: 23 Jul 2007 Last revised: 14 Apr 2022
Date Written: July 2007
High-interest-rate currencies tend to appreciate relative to low-interest-rate currencies. We argue that adverse-selection problems between participants in foreign exchange markets can account for this 'forward premium puzzle.' The key feature of our model is that the adverse selection problem facing market makers is worse when, based on public information, a currency is expected to appreciate.
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