The Forward Premium Puzzle Revisited

Guy Meredith and Yue Ma

No 2002/028, IMF Working Papers from International Monetary Fund

Abstract: The forward premium is a notoriously poor predictor of exchange rate movements. This failure must reflect deviations from risk neutrality and/or rational expectations. In addition, a mechanism is needed that generates the appropriate correlation between the forward premium and shocks arising from risk premia or expectations errors. This paper extends McCallum (1994) to show how such a correlation can arise from the response of monetary policy to output and inflation, which are in turn affected by the exchange rate. The theoretical models considered all generate results that are consistent with the forward premium being a biased predictor of short-term exchange rate movements; the bias decreases, however, as the horizon of the exchange rate change lengthens. Another common feature of the models is that the true reduced-form equation for exchange rate changes contains variables other than the interest differential, providing a justification for "eclectic" relationships for forecasting exchange rates. The results, however, remain consistent with using uncovered interest parity as a building block for structural models.

Keywords: WP; exchange rate; interest rate; Exchange rates; forward premium puzzle; uncovered interest parity; UIP regression; targeting rule; exchange-market disturbance; interest rate differential; slope parameter; exchange rate movement; Exchange rate adjustments; Interest rate parity; Inflation; Currency markets (search for similar items in EconPapers)
Pages: 39
Date: 2002-02-01
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (16)

Downloads: (external link)
http://www.imf.org/external/pubs/cat/longres.aspx?sk=15624 (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:imf:imfwpa:2002/028

Ordering information: This working paper can be ordered from
http://www.imf.org/external/pubs/pubs/ord_info.htm

Access Statistics for this paper

More papers in IMF Working Papers from International Monetary Fund International Monetary Fund, Washington, DC USA. Contact information at EDIRC.
Bibliographic data for series maintained by Akshay Modi ().