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The Forward Discount Puzzle: Identi cation of Economic Assumptions

Seongman Moon () and Carlos Velasco ()

No 1112, Working Papers from Research Institute for Market Economy, Sogang University

Abstract: The forward discount puzzle refers to the robust empirical finding that foreign excess returns are predictable. We investigate if expectations errors are the main cause of this predictability using the serial dependence pattern of excess returns implied by economic models as identification device. This approach also allows us to explain why strong predictability of excess returns only occurs during 1980s. Using USD bilateral spot and forward rates from 1975-2009, we show that both the statistically significant positive serial dependence of excess returns in the entire sample and the very weak (mostly insignificant) positive serial dependence in the subsample excluding observations in 1980-87 are consistent with the predictions of the expectations errors explanation. We provide several pieces of new empirical evidence which support the link between the strong predictability in the 1980s and changes in forecasting techniques by foreign exchange market agents.

Keywords: expectations errors; rational expectations risk premium; excess returns; serial dependence; 1980-87. (search for similar items in EconPapers)
JEL-codes: F31 G14 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-for
Date: 2011-01
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