How Puzzling is the Forward Premium Puzzle? A Meta-Analysis

45 Pages Posted: 3 Aug 2020

See all articles by Diana Zigraiova

Diana Zigraiova

Charles University in Prague

Tomas Havranek

Charles University in Prague; Centre for Economic Policy Research (CEPR)

Jiri Novak

Institute of Economic Studies, Faculty of Social Sciences, Charles University in Prague, Czech Republic

Date Written: July 31, 2020

Abstract

A key theoretical prediction in financial economics is that under risk neutrality and rational expectations, a currency's forward rates should form unbiased predictors of future spot rates. Yet scores of empirical studies report negative slope coefficients from regressions of spot rates on forward rates, which is inconsistent with the forward rate unbiasedness hypothesis. We collect 3,643 estimates from 91 research articles and using recently developed techniques investigate the effect of publication and misspecification biases on the reported results. Correcting for these biases yields slope coefficients of 0.31 and 0.98 for developed and emerging currencies respectively, which implies that empirical evidence is in line with the theoretical prediction for emerging economies and less puzzling than commonly thought for developed economies. Our results also suggest that the coefficients are systematically influenced by the choice of data, numeraire currencies, and estimation methods. The findings can be applied to calibrating carry trade strategies for individual currencies.

Keywords: C83, F31, G14

JEL Classification: Forward rate bias, uncovered interest parity, meta-analysis, publication bias, model uncertainty

Suggested Citation

Zigraiova, Diana and Havranek, Tomas and Novak, Jiri, How Puzzling is the Forward Premium Puzzle? A Meta-Analysis (July 31, 2020). European Stability Mechanism Working Paper No. 46, Available at SSRN: https://ssrn.com/abstract=3666232 or http://dx.doi.org/10.2139/ssrn.3666232

Diana Zigraiova (Contact Author)

Charles University in Prague ( email )

Celetná 13
Praha 1, 116 36
Czech Republic

Tomas Havranek

Charles University in Prague ( email )

Celetná 13
Praha 1, 116 36
Czech Republic

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Jiri Novak

Institute of Economic Studies, Faculty of Social Sciences, Charles University in Prague, Czech Republic ( email )

Opletalova 1606/26
Praha 1, 11000
Czech Republic
+420 222 112 314 (Phone)

HOME PAGE: http://ies.fsv.cuni.cz/cs/staff/novakji

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