Working Paper: NBER ID: w11840
Authors: Jacob Boudoukh; Matthew Richardson; Robert Whitelaw
Abstract: The forward premium anomaly is one of the most robust puzzles in financial economics. We recast the underlying parity relation in terms of cross-country differences between forward interest rates rather than spot interest rates with dramatic results. These forward interest rate differentials have statistically and economically significant forecast power for annual exchange rate movements, both in- and out-of-sample, and the signs and magnitudes of the corresponding coefficients are consistent with economic theory. Forward interest rates also forecast future spot interest rates and future inflation. Thus, we attribute much of the forward premium anomaly to the anomalous behavior of short-term interest rates, not to a breakdown of the link between fundamentals and exchange rates.
Keywords: forward premium anomaly; exchange rates; forward interest rates; predictive power
JEL Codes: G15; F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| short-term interest rates (E43) | expected outcomes (P27) |
| forward interest rate differentials (E43) | future exchange rate movements (F31) |
| forward interest rates (E43) | future spot interest rates (E43) |
| forward interest rates (E43) | future inflation (E31) |