An explanation of the forward premium ‘puzzle’

Richard Roll and Shu Yan

European Financial Management, 2000, vol. 6, issue 2, 121-148

Abstract: Existing literature reports a puzzle about the forward rate premium over the spot foreign exchange rate. The premium is often negatively correlated with subsequent changes in the spot rate. This defies economic intuition and possibly violates market efficiency. Rational explanations include non‐stationary risk premia and econometric mis‐specifications, but some embrace the puzzle as a guide to profitable trading. We suggest there is really no puzzle. A simple model fits the data: forward exchange rates are unbiased predictors of subsequent spot rates. The puzzle arises because the forward rate, the spot rate, and the forward premium follow nearly non‐stationary time series processes. We document these properties with an extended sample and show why they give the delusion of a puzzle.

Date: 2000
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