Can a habit formation model really explain the forward premium anomaly?

Carlos Eugênio da Costa () and Jivago B. Ximenes de Vasconcelos

No 692, FGV EPGE Economics Working Papers (Ensaios Economicos da EPGE) from EPGE Brazilian School of Economics and Finance - FGV EPGE (Brazil)

Abstract: Verdelhan (2009) shows that if one is to explain the foreign exchange forward premium behavior using Campbell and Cochrane (1999)’s habit formation model one must specify it in such a way to generate pro-cyclical short term risk free rates. At the calibration procedure, we show that this is only possible in Campbell and Cochrane’s framework under implausible parameters specifications given that the price-consumption ratio diverges in almost all parameters sets. We, then, adopt Verdelhan’s shortcut of fixing the sensivity function λ(st) at its steady state level to attain a finite value for the price-consumption ratio and release it in the simulation stage to ensure pro-cyclical risk free rates. Beyond the potential inconsistencies that such procedure may generate, as suggested by Wachter (2006), with procyclical risk free rates the model generates a downward sloped real yield curve, which is at odds with the data.

Date: 2009-05-12
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