The Forward Premium Puzzle Revisited
Electronic Access:
Free Download. Use the free Adobe Acrobat Reader to view this PDF file
Summary:
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.
Series:
Working Paper No. 2002/028
Subject:
Currency markets Exchange rate adjustments Exchange rates Financial markets Financial services Foreign exchange Inflation Interest rate parity Prices
English
Publication Date:
February 1, 2002
ISBN/ISSN:
9781451844672/1018-5941
Stock No:
WPIEA0282002
Pages:
39
Please address any questions about this title to publications@imf.org