Working Paper: CEPR ID: DP2169
Authors: Ravi Bansal; Magnus Dahlquist
Abstract: In this paper we document new results regarding the forward premium puzzle. The often found negative correlation between the expected currency depreciation and interest rate differential is, contrary to popular belief, not a pervasive phenomenon. It is confined to developed economies, and here only to states where the U.S. interest rate exceeds foreign interest rates.Furthermore, we find that differences across economies are systematically related to per capita GNP, average inflation rates, and inflation volatility. Our empirical work suggests that it is hard to justify the cross-sectional differences in the risk premia as compensation for systematic risk. Instead, country-specific attributes seem to be important in characterizing the cross-sectional dispersion in the risk premia.
Keywords: forward rates; forward premium; systematic risk
JEL Codes: F31; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| expected currency depreciation (F31) | interest rate differential (E43) |
| interest rate differential (E43) | expected currency depreciation (F31) |
| US interest rates exceed foreign rates (E43) | expected currency depreciation (F31) |
| per capita GNP (D31) | expected currency depreciation (F31) |
| average inflation rates (E31) | expected currency depreciation (F31) |
| inflation volatility (E31) | expected currency depreciation (F31) |
| interest rate differential (E43) | depreciation of the domestic currency (F31) |
| expected currency depreciation (F31) | appreciation of the domestic currency (F31) |