The Forward Premium Puzzle Revisited

February 1, 2002

Preview Citation

Format: Chicago

Guy M Meredith, and Yue Ma. The Forward Premium Puzzle Revisited, (USA: International Monetary Fund, 2002) accessed November 21, 2024

Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

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.

Subject: Currency markets, Exchange rate adjustments, Exchange rates, Financial markets, Financial services, Foreign exchange, Inflation, Interest rate parity, Prices

Keywords: Currency markets, Exchange rate, Exchange rate adjustments, Exchange rate movement, Exchange rates, Exchange-market disturbance, Forward premium puzzle, Inflation, Interest rate, Interest rate differential, Interest rate parity, Slope parameter, Targeting rule, UIP regression, Uncovered interest parity, WP

Publication Details

Pages:

39
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2002/028
Stock No:

WPIEA0282002
ISBN:

9781451844672
ISSN:

1018-5941

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