POSSIBLE SOLUTIONS TO THE FORWARD PREMIUM PUZZLE: A THEMATIC ANALYSIS
Keywords:
Forward Premium Puzzle, Uncovered Interest Rate Parity, Thematic Analysis, Covered Interest Rate Parity, Risk Premium
Abstract
Uncovered interest rate parity (UIP), is one of the crucial relations in macroeconomics and international finance, widely used in the model’s construction and their analytical work. However , empirical regularities in UIP referred to as “Forward Premium Puzzle”, has posed a significant challenge to open-economy models. Thus, the purpose of the study is to identify the possible explanation of the forward premium puzzle. The research has identified five distinct and coherent themes (solutions) using thematic analysis of literature review, namely, risk premium, monetary policy, rational learning and peso-problem, market inefficiency, and lastly, covered interest rate parity. The researcher can use these thematic classifications to understand the operations of the global financial market. Similarly, the identified solutions can help investors in the assessment of their investment strategies such as the risk premium implies returns obtained at the expense of assuming high risk. Thus, investors should question whether average returns received from an investment are above normal on a risk-adjusted basis.References
Adewuyi, A. O., & Ogebe, J. O. (2019). The validity of uncovered interest parity: Evidence from African members and non-member of the organization of petroleum exporting countries (OPEC). Economic Modelling, 82, 229-249.
Akram, Q. F., Rime, D., & Sarno, L. (2008). Arbitrage in the foreign exchange market: Turning on the microscope. Journal of International Economics, 76(2), 237-253.
Alexius, A. (2001). Uncovered Interest Parity Revisited. Review of International Economics, 9(3), 505-517.
Amri, S. (2008). Analyzing the forward premium anomaly using a Logistic Smooth Transition Regression model. Economics Bulletin. 6(26), 1-18.
Aslan, Ő., & Korap, H. L. (2010). Does the uncovered interest parity hold in short horizons? Applied Economics Letters, 17(4), 361-365.
Aysun, U., & Lee, S. (2014). Can time-varying risk premiums explain the excess returns in the interest rate parity condition? Emerging Markets Review, 18, 78-100.
Bacchetta, P., & Wincoop, E. v. (2010). Infrequent Portfolio Decisions: A Solution to the Forward Discount Puzzle. American Economic Review, 100(3), 870-904.
Backus, D. K., Gregory, A. W., & Telmer, C. I. (1993). Accounting for Forward Rates in Markets for Foreign Currency. The Journal of Finance, 48(5), 1887-1908.
Baillie, R. (1983). Testing Rational Expectations and Efficiency in the Foreign Exchange Market. Econometrica, 553-63.
Baillie, R. T., & Bollerslev, T. (2000). The Forward Premium Anomaly is Not as Bad as You Think. Journal of International Money and Finance, 19(4), 471-488.
Bansal, R., & Dahlquist, M. (2000). The forward premium puzzle: different tales from developed and emerging economies. Journal of International Economics, 51(1), 115-144.
Bekaert, G., & Hodrick, R. J. (2000). Expectations Hypotheses Tests. The journal of finance, 56(4), 1357-1394.
Berg, B. L. (1995). Methods for the social sciences. Qualitative Research Methods for the Social Sciences. Boston: Pearson Education.
Biswas, R., Piccotti, L. R., & Schreiber, B. Z. (2019). Differential Risk Premiums and the UIP Puzzle. SSRN.
Burnside, C., Eichenbaum, M., Kleshchelski, I., & Rebelo, S. (2011). Do Peso Problems Explain the Returns to the Carry Trade? The Review of Financial Studies, 24(3), 853-891.
Burnside, C. (2011). The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk: Comment. The American Economic Review, 101(7), 3456-3476.
Burnside, C. (2013). New Zealand’s risk premium. New Zealand Economic Papers, 47(1), 27– 52.
Burnside, C., Han, B., Hirshleifer, D., & Wang, T. Y. (2011). Investor Overconfidence and the Forward Premium Puzzle. Review of Economic Studies, 78(2), 523-558.
Cerutti, E., Obstfeld, M., & Zhou, H. (2019). Covered interest parity deviations: Macro financial determinants (No. w26129). National Bureau of Economic Research.
Chang, S. S. (2011). On the (in)feasibility of covered interest parity as a solution to the forward bias puzzle. Journal of Internation Financial Markets, Institution & Money, 21(4), 611- 616.
Chinn, M. (2006). The (Partial) Rehabilitation of Interest Rate Parity in the Floating Era: Longer Horizons, Alternative Expectations, and Emerging Markets. Journal of International Money and Finance, 25(1), 7-21.
Chinn, M. D., & Meredith, G. (2005). Testing Uncovered Interest Parity at Short and Long Horizons during the Post-Bretton Woods Era. NBER.
Chinn, M. D., & Meredith, G. ( 2004). Monetary policy and long-horizon uncovered interest parity. IMF staff papers, 51(3), 409-430.
BIBLIOGRAPHY Chinn, M. D., & Zhang, Y. (2015). Uncovered interest parity and monetary policy near and far from the zero lower bound. Open Economies Review, 29(1), 1-30.
Cho, D. (2015). The Role of Covered Interest Parity in Explaining the Forward Premium Anomaly Within a Nonlinear Panel Framework. Journal of Empirical Finance34, 229-238.
Chu, S.-Y. (2015). Funding liquidity constraints and forward premium anomaly in a DSGE model. International Review of Economics and Finance, 39, 76-89.
Coudert, V., & Mignon, V. (2013). The “forward premium puzzle” and the sovereign default risk. Journal of International Money and Finance, 32, 491-511.
Engel, C. (1996). The forward discount anomaly and the risk premium: A survey of recent evidence. Journal of Empirical Finance, 3(2), 123-192.
Fama, E. F. (1984). Forward and Spot Exchange Rates. Journal of Monetary Economics, 14(3), 319-338.
Fisher, I. (1896). Appreciation and Interest. New York: Macmillan. Fisher, I. (1907). The Rate of Interest. New York: Macmillan.
Fisher, I. (1930). The Theory of Interest. New York and London: Macmillan.
Frankel, J., & Poonawala, J. (2006). The forward market in emerging currencies: Less biased than in major currencies. Journal of International Money and Finance, 29(3), 585-598.
Froot, K. A., & Frankel, J. A. (1989). Forward Discount Bias: Is it an Exchange Risk Premium? The Quarterly Journal of Economics, 104(1), 139-161.
Froot, K. A. (1990). Short rates and expected asset returns (No. w3247). National Bureau of Economic Research.
Golinelli, R., & Rovelli, R. (2005). Monetary policy transmission, interest rate rules, and inflation targeting in three transition countries. Journal of Banking & Finance, 29(1), 183-201.
Guender, A. V. (2014). Monetary Policy and the Uncovered Interest Rate Parity Puzzle: Theory and Empirical Results for Oceania. Economic Record, 90(289), 207–219.
Hai, W., Mark, N. C., & Wu, Y. (1997). Understanding Spot and Forward Exchange Rate Regressions. Journal of Applied Econometrics, 12(6), 715-734.
Hansen, L. P., & Hodrick, R. J. (1980). Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis. Journal of Political Economy, 88(5), 829-853.
Hassan, T. A., & Mano, R. C. (2017). Forward and Spot Exchange Rates in a Multi-Currency World. Fama-Miller Working Paper.
Hochradl, M., & Wagner, C. (2010). Trading the forward bias: Are there limits to speculation? Journal of International Money and Finance, 29(3), 423-441.
Hopper, G. P. (1994). Is Foreign Exchange Market Inefficient. Federal Reserve Bank of Philadelphia Business Review.
Kang, M.-W. (2019). Currency Market Efficiency Revisited: Evidence from Korea. International Journal of Financial Studies. 7(3), 52.
Keynes, J. M. (1923 ). A Tract on Monetary Reform. London: Macmillan and Co., Limited.
Keynes, J. M. (1936). The General Theory of Employment, Interest, and Money. London: Macmillan.
King, A. (2011). A comment on: “The solution to the forward premium puzzle.” Journal of International Financial Markets, Institution & Money, 21(4), 623-628.
Kirikos, D. G. (2002). Discrete policy interventions and rational forecast errors in foreign exchange markets: the uncovered interest parity hypothesis revisited. Journal of Finance and Economics, 7(4), 327-338.
Krishnakumar, J., & Neto, D. (2008). Testing Uncovered Interest Rate Parity and Term Structure Using Multivariate Threshold Cointegration. Computational Methods in Financial Engineering, 191-210.
Kumar, S., Pathak, R., & Ranajee. (2014). Forward premium anomaly and Risk Premium in the currency markets. Indian Journal of Finance, 47.
Lee, B.-J. (2013). Uncovered interest parity puzzle: Asymmetric responses. International Review of Economics & Finance, 27, 238-249.
Li, D., Ghoshray, A., & Morley, B. (2012). Measuring the risk premium in uncovered interest parity using the component GARCH-M model. International Review of Economics and Finance, 24, 167176.
Lothian, J. R., Pownall, R. A., & Koedijk, K. G. (2013). I discovered the peso problem: Irving Fisher and the UIP puzzle. Journal of International Money and Finance, 38, 5-17.
Lustig, H., & Verdelhan, A. (2011). The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk: Reply. American Economic Review, 101(7), 3477–3500.
Lustig, H., & Verdelhan, A. (2007). The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk. American Economic Review, 97(1), 89-117.
MacDonald, R., & Taylor, M. P. (1990). The Term Structure of Forward Foreign Exchange Premia: The InterWar Experience. The Manchester School, 58(1), 54-65.
McCallum, B. T. (1996). International Monetary Economics. London: Oxford University Press. Meredith, G., & Ma, Y. (2002). The forward premium puzzle revisited (No. 2-28). International Monetary Fund.
Moran, K., & Nono, S. A. (2018). Gradual learning about shocks and the forward premium puzzle. Journal of International Money and Finance, 88, 79-100.
Nagayasu, J. (2014). The forward premium puzzle and the Euro. Journal of International Financial Markets, Institutions, and Money, 32, 436-451.
Paol, B. D., & Sondergaard, J. (2016). Revisiting the forward premium anomaly using consumption habits: a new Keynesian model. Economica, 84(335), 516-540.
Paya, I., Peel, D. A., & Spiru, A. (2010). The forward premium puzzle in the interwar period and deviations from covered. Economics Letters, 108(1), 55–57.
Pippenger, J. (2011). The solution to the forward-bias puzzle. Journal of International Financial Markets, Institutions & Money, 21(2), 296-304.
Rabitsch, K. (2016). An Incomplete Markets Explanation of the Uncovered Interest Rate Parity Puzzle. Review of International Economics, 24(2), 422–446.
Sakoulis, G., Zivot, E., & Choi, K. (2010). Structural Change in the forward discount: Implications for the forward rate unbiasedness hypothesis. Journal of Empirical Finance, 17(5), 957- 966.
Snaith, S., Coakley, J., & Kellard, N. (2013). Does the forward premium puzzle disappear over the horizon? Journal of Banking and Finance, 37(9), 3681-3693.
Tang, K. B. (2011). The Precise Form of Uncovered Interest Parity: A Heterogeneous Panel. Economic Modelling, 28(1-2), 568-573.
Ullrich, C. (2009). Forecasting and Hedging in the Foreign Exchange Markets. Springer Science & Business Media.
Vasilyev, D., Busygin, V., & Busygin, S. (2017). Testing and interpreting uncovered interest parity in Russia. Russian Journal of Economics, 3(2), 158-173.
Verdelhan, A. (2010). A Habit-Based Explanation of the Exchange Rate Risk Premium. The Journal of Finance, 65(1), 123-146.
Weber, E. (2011). What Happened with the Transatlantic Capital Market Relations. Economic Modelling, 28(3), 577-884.
Yu, J. (2013). A sentiment-based explanation of the forward premium puzzle. Journal of Monetary Economics, 60(4), 474-491.
Zhou, H., & Londono, J. M. (2017). Variance risk premiums and the forward premium puzzle. Journal of Financial Economics, 124(2), 415-440.
Akram, Q. F., Rime, D., & Sarno, L. (2008). Arbitrage in the foreign exchange market: Turning on the microscope. Journal of International Economics, 76(2), 237-253.
Alexius, A. (2001). Uncovered Interest Parity Revisited. Review of International Economics, 9(3), 505-517.
Amri, S. (2008). Analyzing the forward premium anomaly using a Logistic Smooth Transition Regression model. Economics Bulletin. 6(26), 1-18.
Aslan, Ő., & Korap, H. L. (2010). Does the uncovered interest parity hold in short horizons? Applied Economics Letters, 17(4), 361-365.
Aysun, U., & Lee, S. (2014). Can time-varying risk premiums explain the excess returns in the interest rate parity condition? Emerging Markets Review, 18, 78-100.
Bacchetta, P., & Wincoop, E. v. (2010). Infrequent Portfolio Decisions: A Solution to the Forward Discount Puzzle. American Economic Review, 100(3), 870-904.
Backus, D. K., Gregory, A. W., & Telmer, C. I. (1993). Accounting for Forward Rates in Markets for Foreign Currency. The Journal of Finance, 48(5), 1887-1908.
Baillie, R. (1983). Testing Rational Expectations and Efficiency in the Foreign Exchange Market. Econometrica, 553-63.
Baillie, R. T., & Bollerslev, T. (2000). The Forward Premium Anomaly is Not as Bad as You Think. Journal of International Money and Finance, 19(4), 471-488.
Bansal, R., & Dahlquist, M. (2000). The forward premium puzzle: different tales from developed and emerging economies. Journal of International Economics, 51(1), 115-144.
Bekaert, G., & Hodrick, R. J. (2000). Expectations Hypotheses Tests. The journal of finance, 56(4), 1357-1394.
Berg, B. L. (1995). Methods for the social sciences. Qualitative Research Methods for the Social Sciences. Boston: Pearson Education.
Biswas, R., Piccotti, L. R., & Schreiber, B. Z. (2019). Differential Risk Premiums and the UIP Puzzle. SSRN.
Burnside, C., Eichenbaum, M., Kleshchelski, I., & Rebelo, S. (2011). Do Peso Problems Explain the Returns to the Carry Trade? The Review of Financial Studies, 24(3), 853-891.
Burnside, C. (2011). The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk: Comment. The American Economic Review, 101(7), 3456-3476.
Burnside, C. (2013). New Zealand’s risk premium. New Zealand Economic Papers, 47(1), 27– 52.
Burnside, C., Han, B., Hirshleifer, D., & Wang, T. Y. (2011). Investor Overconfidence and the Forward Premium Puzzle. Review of Economic Studies, 78(2), 523-558.
Cerutti, E., Obstfeld, M., & Zhou, H. (2019). Covered interest parity deviations: Macro financial determinants (No. w26129). National Bureau of Economic Research.
Chang, S. S. (2011). On the (in)feasibility of covered interest parity as a solution to the forward bias puzzle. Journal of Internation Financial Markets, Institution & Money, 21(4), 611- 616.
Chinn, M. (2006). The (Partial) Rehabilitation of Interest Rate Parity in the Floating Era: Longer Horizons, Alternative Expectations, and Emerging Markets. Journal of International Money and Finance, 25(1), 7-21.
Chinn, M. D., & Meredith, G. (2005). Testing Uncovered Interest Parity at Short and Long Horizons during the Post-Bretton Woods Era. NBER.
Chinn, M. D., & Meredith, G. ( 2004). Monetary policy and long-horizon uncovered interest parity. IMF staff papers, 51(3), 409-430.
BIBLIOGRAPHY Chinn, M. D., & Zhang, Y. (2015). Uncovered interest parity and monetary policy near and far from the zero lower bound. Open Economies Review, 29(1), 1-30.
Cho, D. (2015). The Role of Covered Interest Parity in Explaining the Forward Premium Anomaly Within a Nonlinear Panel Framework. Journal of Empirical Finance34, 229-238.
Chu, S.-Y. (2015). Funding liquidity constraints and forward premium anomaly in a DSGE model. International Review of Economics and Finance, 39, 76-89.
Coudert, V., & Mignon, V. (2013). The “forward premium puzzle” and the sovereign default risk. Journal of International Money and Finance, 32, 491-511.
Engel, C. (1996). The forward discount anomaly and the risk premium: A survey of recent evidence. Journal of Empirical Finance, 3(2), 123-192.
Fama, E. F. (1984). Forward and Spot Exchange Rates. Journal of Monetary Economics, 14(3), 319-338.
Fisher, I. (1896). Appreciation and Interest. New York: Macmillan. Fisher, I. (1907). The Rate of Interest. New York: Macmillan.
Fisher, I. (1930). The Theory of Interest. New York and London: Macmillan.
Frankel, J., & Poonawala, J. (2006). The forward market in emerging currencies: Less biased than in major currencies. Journal of International Money and Finance, 29(3), 585-598.
Froot, K. A., & Frankel, J. A. (1989). Forward Discount Bias: Is it an Exchange Risk Premium? The Quarterly Journal of Economics, 104(1), 139-161.
Froot, K. A. (1990). Short rates and expected asset returns (No. w3247). National Bureau of Economic Research.
Golinelli, R., & Rovelli, R. (2005). Monetary policy transmission, interest rate rules, and inflation targeting in three transition countries. Journal of Banking & Finance, 29(1), 183-201.
Guender, A. V. (2014). Monetary Policy and the Uncovered Interest Rate Parity Puzzle: Theory and Empirical Results for Oceania. Economic Record, 90(289), 207–219.
Hai, W., Mark, N. C., & Wu, Y. (1997). Understanding Spot and Forward Exchange Rate Regressions. Journal of Applied Econometrics, 12(6), 715-734.
Hansen, L. P., & Hodrick, R. J. (1980). Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis. Journal of Political Economy, 88(5), 829-853.
Hassan, T. A., & Mano, R. C. (2017). Forward and Spot Exchange Rates in a Multi-Currency World. Fama-Miller Working Paper.
Hochradl, M., & Wagner, C. (2010). Trading the forward bias: Are there limits to speculation? Journal of International Money and Finance, 29(3), 423-441.
Hopper, G. P. (1994). Is Foreign Exchange Market Inefficient. Federal Reserve Bank of Philadelphia Business Review.
Kang, M.-W. (2019). Currency Market Efficiency Revisited: Evidence from Korea. International Journal of Financial Studies. 7(3), 52.
Keynes, J. M. (1923 ). A Tract on Monetary Reform. London: Macmillan and Co., Limited.
Keynes, J. M. (1936). The General Theory of Employment, Interest, and Money. London: Macmillan.
King, A. (2011). A comment on: “The solution to the forward premium puzzle.” Journal of International Financial Markets, Institution & Money, 21(4), 623-628.
Kirikos, D. G. (2002). Discrete policy interventions and rational forecast errors in foreign exchange markets: the uncovered interest parity hypothesis revisited. Journal of Finance and Economics, 7(4), 327-338.
Krishnakumar, J., & Neto, D. (2008). Testing Uncovered Interest Rate Parity and Term Structure Using Multivariate Threshold Cointegration. Computational Methods in Financial Engineering, 191-210.
Kumar, S., Pathak, R., & Ranajee. (2014). Forward premium anomaly and Risk Premium in the currency markets. Indian Journal of Finance, 47.
Lee, B.-J. (2013). Uncovered interest parity puzzle: Asymmetric responses. International Review of Economics & Finance, 27, 238-249.
Li, D., Ghoshray, A., & Morley, B. (2012). Measuring the risk premium in uncovered interest parity using the component GARCH-M model. International Review of Economics and Finance, 24, 167176.
Lothian, J. R., Pownall, R. A., & Koedijk, K. G. (2013). I discovered the peso problem: Irving Fisher and the UIP puzzle. Journal of International Money and Finance, 38, 5-17.
Lustig, H., & Verdelhan, A. (2011). The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk: Reply. American Economic Review, 101(7), 3477–3500.
Lustig, H., & Verdelhan, A. (2007). The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk. American Economic Review, 97(1), 89-117.
MacDonald, R., & Taylor, M. P. (1990). The Term Structure of Forward Foreign Exchange Premia: The InterWar Experience. The Manchester School, 58(1), 54-65.
McCallum, B. T. (1996). International Monetary Economics. London: Oxford University Press. Meredith, G., & Ma, Y. (2002). The forward premium puzzle revisited (No. 2-28). International Monetary Fund.
Moran, K., & Nono, S. A. (2018). Gradual learning about shocks and the forward premium puzzle. Journal of International Money and Finance, 88, 79-100.
Nagayasu, J. (2014). The forward premium puzzle and the Euro. Journal of International Financial Markets, Institutions, and Money, 32, 436-451.
Paol, B. D., & Sondergaard, J. (2016). Revisiting the forward premium anomaly using consumption habits: a new Keynesian model. Economica, 84(335), 516-540.
Paya, I., Peel, D. A., & Spiru, A. (2010). The forward premium puzzle in the interwar period and deviations from covered. Economics Letters, 108(1), 55–57.
Pippenger, J. (2011). The solution to the forward-bias puzzle. Journal of International Financial Markets, Institutions & Money, 21(2), 296-304.
Rabitsch, K. (2016). An Incomplete Markets Explanation of the Uncovered Interest Rate Parity Puzzle. Review of International Economics, 24(2), 422–446.
Sakoulis, G., Zivot, E., & Choi, K. (2010). Structural Change in the forward discount: Implications for the forward rate unbiasedness hypothesis. Journal of Empirical Finance, 17(5), 957- 966.
Snaith, S., Coakley, J., & Kellard, N. (2013). Does the forward premium puzzle disappear over the horizon? Journal of Banking and Finance, 37(9), 3681-3693.
Tang, K. B. (2011). The Precise Form of Uncovered Interest Parity: A Heterogeneous Panel. Economic Modelling, 28(1-2), 568-573.
Ullrich, C. (2009). Forecasting and Hedging in the Foreign Exchange Markets. Springer Science & Business Media.
Vasilyev, D., Busygin, V., & Busygin, S. (2017). Testing and interpreting uncovered interest parity in Russia. Russian Journal of Economics, 3(2), 158-173.
Verdelhan, A. (2010). A Habit-Based Explanation of the Exchange Rate Risk Premium. The Journal of Finance, 65(1), 123-146.
Weber, E. (2011). What Happened with the Transatlantic Capital Market Relations. Economic Modelling, 28(3), 577-884.
Yu, J. (2013). A sentiment-based explanation of the forward premium puzzle. Journal of Monetary Economics, 60(4), 474-491.
Zhou, H., & Londono, J. M. (2017). Variance risk premiums and the forward premium puzzle. Journal of Financial Economics, 124(2), 415-440.
Published
2020-01-15
Section
Articles
