The Forward Discount Puzzle: Identification of Economic Assumptions

50 Pages Posted: 23 Jan 2011

See all articles by Seongman Moon

Seongman Moon

Universidad Carlos III de Madrid - Department of Economics

Carlos Velasco

Universidad Carlos III de Madrid - Department of Economics

Date Written: January 4, 2011

Abstract

The forward discount puzzle refers to the robust empirical finding that foreign excess returns are predictable. We investigate if expectations errors are the main cause of this predictability using the serial dependence pattern of excess returns implied by economic models as identification device. This approach also allows us to explain why strong predictability of excess returns only occurs during 1980s. Using USD bilateral spot and forward rates from 1975-2009, we show that both the statistically significant positive serial dependence of excess returns in the entire sample and the very weak (mostly insignificant) positive serial dependence in the subsample excluding observations in 198'287 are consistent with the predictions of the expectations errors explanation. We provide several pieces of new empirical evidence which support the link between the strong predictability in the 1980s and changes in forecasting techniques by foreign exchange market agents.

Suggested Citation

Moon, Seongman and Velasco, Carlos, The Forward Discount Puzzle: Identification of Economic Assumptions (January 4, 2011). Available at SSRN: https://ssrn.com/abstract=1745443 or http://dx.doi.org/10.2139/ssrn.1745443

Seongman Moon (Contact Author)

Universidad Carlos III de Madrid - Department of Economics ( email )

Calle Madrid 126
Getafe, 28903
Spain

Carlos Velasco

Universidad Carlos III de Madrid - Department of Economics ( email )

Calle Madrid 126
Getafe, 28903
Spain
+34-91 6249646 (Phone)
+34-91 6249875 (Fax)

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