Working Paper: CEPR ID: DP6399
Authors: Craig Burnside; Martin Eichenbaum; Sergio Rebelo
Abstract: High-interest-rate currencies tend to appreciate relative to low-interest-rate currencies. We argue that adverse-selection problems between participants in foreign exchange markets can account for this `forward premium puzzle.' The key feature of our model is that the adverse selection problem facing market makers is worse when, based on public information, a currency is expected to appreciate.
Keywords: exchange rates; microstructure; uncovered interest parity
JEL Codes: F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Adverse selection problems between market makers and traders (D82) | Negative covariance between forward premium and changes in exchange rates (F31) |
| Market maker receives a buy order (C69) | Higher probability it comes from an informed trader who expects currency to appreciate (F31) |
| Higher probability it comes from an informed trader who expects currency to appreciate (F31) | Higher ask forward rates when currency is expected to depreciate (F31) |
| Negative covariance between forward premium and changes in exchange rates (F31) | Forward premium puzzle persists in the data (Y10) |
| Adverse selection mechanism (D82) | Explain forward premium puzzle while maintaining low volatility in forward premiums and interest rates (E43) |