Imperfect Knowledge, Temporal Instability and an Uncertainty Premium: Towards a Resolution of the Excess-Returns Puzzle in the Foreign Exchange Market

Roman Frydman and Michael D. Goldberg
Additional contact information
Roman Frydman: New York University
Michael D. Goldberg: University of New Hampshire and Institute of Economics, University of Copenhagen

No 02-17, Discussion Papers from University of Copenhagen. Department of Economics

Abstract: This paper offers a refinement and explores a resolution of the excess-returns puzzle in the foreign exchange market. We find that the predictions of the forward premium are not negatively biased throughout the three decades of floating, as commonly believed, but rather are sometimes positively biased, negatively biased, unbiased or possess no predictive content depending on the subperiod examined. To explain this modified puzzle, the paper makes use of a recently developed model of the risk premium, which we have called an aggregate uncertainty premium. Our model employs an alternative approach to modeling exchange rate expectations, dubbed Imperfect Knowledge Expectations (IKE), which recognizes that rational agents do form expectations based on imperfect knowledge. Our model also makes use of a dynamic extension of the assumption of myopic loss aversion. We find that our IKE-based approach can account for the pattern of positive and negative biases estimated over three decades of floating rates.

Keywords: exchange rates; forward-premium anomaly; instability; imperfect knowledge expectations; risk premium (search for similar items in EconPapers)
JEL-codes: F3 (search for similar items in EconPapers)
Pages: 47 pages
Date: 2002-10, Revised 2002-11
New Economics Papers: this item is included in nep-fmk and nep-ifn
References: View complete reference list from CitEc
Citations: View citations in EconPapers (1)

Downloads: (external link)
http://www.econ.ku.dk/english/research/publications/wp/2002/0217.pdf/ (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:kud:kuiedp:0217

Access Statistics for this paper

More papers in Discussion Papers from University of Copenhagen. Department of Economics Oester Farimagsgade 5, Building 26, DK-1353 Copenhagen K., Denmark. Contact information at EDIRC.
Bibliographic data for series maintained by Thomas Hoffmann ().