 Liquidity shocks: A new solution to the forward premium puzzleVikram Kumar Economic Modelling, 2020, vol. 91, issue C, 445-454 Abstract: The frequent empirical failure of uncovered interest rate parity raises a question that has not been definitively answered: why do predictable excess returns on currencies persist in competitive currency markets? Supported by data from nine major currencies for 1978:08–2019:09, I provide a novel resolution to this enduring forward premium puzzle by building on the financial economics literature that explores the economic implications of limited access to capital markets. A liquidity shock, or the urgent demand for liquidity by credit-constrained arbitragers liquidating bond holdings, causes losses from sudden drops in bond prices. Arbitragers require a liquidity premium to compensate for potential losses that vary directly with the interest rate. It is this liquidity premium that explains persistent excess returns on currencies. I argue for policies favoring a low interest rate environment and macroprudential controls that ease liquidity constraints to increase the efficiency of international capital markets by reducing the liquidity premium. Keywords: Liquidity shock; Liquidity premium; UIP failure; Forward premium puzzle; Forward discount bias; Liquidity risk-augmented UIP (search for similar items in EconPapers) Downloads: (external link) Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: https://EconPapers.repec.org/RePEc:eee:ecmode:v:91:y:2020:i:c:p:445-454 DOI: 10.1016/j.econmod.2020.06.006 Access Statistics for this article Economic Modelling is currently edited by S. Hall and P. Pauly More articles in Economic Modelling from Elsevier |
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