A long lasting puzzle in international finance is the forward premium anomaly in currency markets. It refers to the well-documented empirical phenomenon [e.g. Hodrick (1987)] that the slope coefficient from the linear projection of the change in the exchange rate on the interest rate differential is significantly negative, implying that the domestic currency is expected to appreciate when domestic interest rates exceed the foreign interest rates. This is puzzling because economic intuition suggests that international investors would demand higher interest rates on currencies expected to fall in value as implied by the uncovered interest rate parity (henceforth UIP).
Among many different explanations that have been proposed to rationalize this anomaly, Lewis (1994) and Evans (1995) discuss the peso problem as a possible cause of the forward premium puzzle. Frankel and Ross (1994) surveys the literature on irrational expectations and speculative bubbles in currency markets. McCallum (1994) considers the influence of monetary policy on the exchange rate. Baillie and Bollerslev (2000) suggests that that the anomaly can be viewed as a statistical artifact due to a small sample size and the persistent autocorrelation in the forward premiums.
Alternatively, the deviations from the uncovered interest rate parity can be interpreted as time-varying risk premiums from investing in foreign currencies by rational and risk-averse investors. As pointed out by Fama (1984), however, for time-varying risk premiums to explain the negative correlation between changes in the exchange rate and the interest rate differential, the risk premiums must be negatively correlated with the subsequent depreciation of the foreign currency.
And more importantly the risk premiums must be extremely volatile. In most cases, the standard deviation of the risk premiums should be even larger than that of the expected change in the exchange rate.
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Macroeconomic Shocks and the Foreign Exchange Risk Premiums
