The Forward Premium Puzzle Revisited

40 Pages Posted: 29 Jan 2006

See all articles by Guy Meredith

Guy Meredith

International Monetary Fund (IMF) - Research Department

Yue Ma

City University of Hong Kong (CityU) - Department of Economics & Finance

Date Written: February 2002

Abstract

The forward premium is a notoriously poor predictor of exchange rate movements. This failure must reflect deviations from risk neutrality and/or rational expectations. In addition, a mechanism is needed that generates the appropriate correlation between the forward premium and shocks arising from risk premia or expectations errors. This paper extends McCallum (1994) to show how such a correlation can arise from the response of monetary policy to output and inflation, which are in turn affected by the exchange rate. The theoretical models considered all generate results that are consistent with the forward premium being a biased predictor of short-term exchange rate movements; the bias decreases, however, as the horizon of the exchange rate change lengthens. Another common feature of the models is that the true reduced-form equation for exchange rate changes contains variables other than the interest differential, providing a justification for eclectic relationships for forecasting exchange rates. The results, however, remain consistent with using uncovered interest parity as a building block for structural models.

Keywords: Exchange rates, forward premium puzzle, uncovered interest parity

JEL Classification: F31, F47, F41

Suggested Citation

Meredith, Guy and Ma, Yue, The Forward Premium Puzzle Revisited (February 2002). IMF Working Paper No. 02/28, Available at SSRN: https://ssrn.com/abstract=879384

Guy Meredith (Contact Author)

International Monetary Fund (IMF) - Research Department ( email )

700 19th Street NW
Washington, DC 20431
United States

Yue Ma

City University of Hong Kong (CityU) - Department of Economics & Finance ( email )

83 Tat Chee Avenue
Kowloon
Hong Kong

HOME PAGE: http://www.cb.cityu.edu.hk/staff/yuema24

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