The Forward Premium Anomaly: Three Examples in Search of a Solution
32 Pages Posted: 11 Nov 2008
Date Written: July 1994
Perhaps the most puzzling feature of currency prices is the tendency for high interest rate currencies to appreciate, when the expectations hypothesis suggest the reverse. This forward premium anomaly has been attributed, by some, to a time-varying risk premium, but theory has yet to produce a risk premium with the requisite properties. We characterize the risk premium in a general theoretical framework and construct three examples that illustrate features a theoretical explanation of the anomaly is likely to have.
Keywords: forward and spot exchange rates, risk premium, pricing kernels, bond pricing
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