Understanding the Forward Premium Puzzle: A Microstructure Approach

Craig Burnside (), Martin Eichenbaum and Sergio Rebelo ()

American Economic Journal: Macroeconomics, 2009, vol. 1, issue 2, pages 127-54

Abstract: High interest rate currencies tend to appreciate relative to low interest rate currencies. We argue that adverse selection problems between participants in foreign exchange markets can account for this "forward premium puzzle." The key feature of our model is that the adverse selection problem facing market makers is worse when an agent wants to trade against a public information signal. So, when based on public information, the currency is expected to appreciate, there is more adverse selection associated with a sell order than with a buy order. (JEL E43, F31, G15)

Date: 2009
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Related works:
Working Paper: Understanding the Forward Premium Puzzle: A Microstructure Approach (2007)
Working Paper: Understanding the Forward Premium Puzzle: A Microstructure Approach (2007)
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