an explanation of the forward premium puzzle
DESCRIPTION
Roll, Richard and Yan, Shu (1998). “An Explanation of the Forward Premium ‘Puzzle’” Anderson School UCLA, Capital Management Sciences, Working Paper #11-98, June 16, 1998.Existing Literature reports an empirical puzzle about the foreign exchange forward premium, the spread between the forward rate and the concurrently-observed spot exchange rate. The premium is often negatively correlated with subsequent changes in the spot rate. This defies economic intuition and possibly violates market efficiency. Roll and Shu (1998) suggest there is really no puzzle at all. The simplest conceivable model adequately fits the data; forward exchange rates are unbiased predictors of subsequent spot rates. The puzzle has arisen because (a) the forward rate, the spot rate, and the forward premium all follow non-stationary (or nearly so) time series processes, and (b) the forward rate is a noisy predictor. The authors document these features with an extended sample and show how they can give the delusion of a puzzle.TRANSCRIPT
