Working Paper: NBER ID: w24342
Authors: Matthieu Bussiere; Menzie D. Chinn; Laurent Ferrara; Jonas Heipertz
Abstract: We re-examine the historically common finding that ex post depreciation and the forward premium are negatively correlated, termed the forward premium puzzle. When covered interest differentials are zero, this finding is equivalent to the rejection of the joint hypothesis of uncovered interest parity (UIP) and full information rational expectations. We term this result the Fama puzzle (1984), given the difficulty in identifying a time-varying risk premium that could rationalize this result. In our analysis, the rejection occurs for eight exchange rates against the US dollar, but does not survive into the period during and in the decade after the financial crisis. Strikingly, in contrast to earlier findings, the Fama coefficient – the coefficient on the interest differential – then becomes large and positive; this is what we term the New Fama Puzzle. Using survey based measures of exchange rate expectations, we find much more constant evidence in favor of UIP. Hence, the explanation for the switch in the Fama coefficient in the wake of the global financial crisis is mostly a change in how expectations errors and interest differentials co-move.
Keywords: No keywords provided
JEL Codes: F31; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Interest differentials (E43) | Exchange rate changes (F31) |
| Expectations errors (D84) | Interest differentials (E43) |
| Expectations errors (D84) | Exchange rate changes (F31) |
| Changes in the correlation of expectations errors and interest differentials (E49) | Understanding the Fama puzzle (G11) |
| Fama coefficient changes (C22) | Interest differentials predicting exchange rate changes (E43) |
| VIX inclusion (G24) | Fama regression results (C29) |