The Forward Puzzle: the Roles of Exchange-Rate Regime and Base-Currency Strength
26 Pages Posted: 5 Mar 2008
Date Written: March 4, 2008
The forward puzzle is traditionally explained as the presence of a covariance-risk premium (Bansal, 1997), market friction (Huisman et al, 1998) or limits to arbitrage (Sarno et al, 2006). More recently, Liu and Sercu (2007) present evidence consistent with career-risk or fallen-angel hypothesis, which states that portfolio managers shun assets with danger signals, like a strong forward discount, unlike most other, their test work is with intra-ERM rates for the DEM. So, the question arises whether this pattern is also existing in floating rates against the USD; and if not, what makes the diference: is it the exchange rate regime or the strength of the base currency? Thus, in this paper we apply the Liu-Sercu tests to (i) mainstream floating rates against the USD; (ii) the HKD pegged to the USD; (iii) intra-ERM rates for the DEM, a strong base currency; and (iv) intra-ERM rates for the ITL, a weak base currency. We find that the floaters support market friction or limit-to-arbitrage theories but the nonlinearity of the model is insignificant. Under the band regimes, the nonlinearity is more significant, the strong currencies favorite market friction and limit-to-arbitrage theories but the weak currencies support the career-risk effect. We also find that the forward premium is less stationary under the floating regime than the band regimes. So, we decompose the forward premium into a long-run trend and short-term filtered component. When the cubic models are in terms of the trends, the career-risk effect is dominant for the weak currencies, the market-friction and limit-to-arbitrage theories are favorable for the strong currencies. When the regressors are the filtered components, the career-risk effect is unique for the weak currencies under the band regimes. To recognize "extreme" observations the strong floaters base on the trend components, while the weak floaters and band-regime currencies base on the filtered components.
Keywords: forward puzzle, exchange rate regime, base-currency strength, nonstationarity, career-risk effect
JEL Classification: G15, G32
Suggested Citation: Suggested Citation