Working Paper: NBER ID: w13278
Authors: Craig Burnside; Martin S. 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: forward premium puzzle; adverse selection; foreign exchange markets; microstructure
JEL Codes: E30; F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| adverse selection (D82) | forward premium puzzle (F31) |
| public information indicating appreciation (H49) | adverse selection (D82) |
| informed traders (G14) | negative covariance with forward premiums (G19) |
| forward premium increases (F31) | expected change in exchange rate decreases (F31) |