Econometrics of the forward premium puzzle

Stephen E. Haynes () and Avik Chakraborty

University of Oregon Economics Department Working Papers from University of Oregon Economics Department

Abstract: This paper explores from a new perspective the forward premium puzzle, i.e., why a regression of the change in the future spot exchange rate on the forward premium paradoxically yields a coefficient that is frequently negative. This traditional specification is compared theoretically and empirically to a "level" regression of the future spot rate on the current forward rate, which does not display the puzzle. We explore both non-rationality and risk premium explanations. The general conclusion is that, with non-rationality, any modest deviation from unity in the level coefficient becomes greatly magnified in the forward premium coefficient because of the stationary/nonstationary properties of the relevant variables, thereby generating the puzzle.

Keywords: Forward premium puzzle; Spot and forward exchange rates; Foreign exchange market efficiency; Non-rationality in foreign exchange markets (search for similar items in EconPapers)
JEL-codes: F30 F31 (search for similar items in EconPapers)
Pages: 23
Date: 2005-10-15
New Economics Papers: this item is included in nep-fin and nep-ifn
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Persistent link: https://EconPapers.repec.org/RePEc:ore:uoecwp:2005-18

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