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An explanation of the forward premium 'puzzle'

Roll, Richard and Yan, Shu (2000) An explanation of the forward premium 'puzzle'. European Financial Management, 6 (2). pp. 121-148. ISSN 1354-7798.

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Existing literature reports a puzzle about the forward rate premium over the spot foreign exchange rate. The premium is often negatively correlated with subsequent changes in the spot rate. This defies economic intuition and possibly violates market efficiency. Rational explanations include non‐stationary risk premia and econometric mis‐specifications, but some embrace the puzzle as a guide to profitable trading. We suggest there is really no puzzle. A simple model fits the data: forward exchange rates are unbiased predictors of subsequent spot rates. The puzzle arises because the forward rate, the spot rate, and the forward premium follow nearly non‐stationary time series processes. We document these properties with an extended sample and show why they give the delusion of a puzzle.

Item Type:Article
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Additional Information:© 2000 Blackwell Publishers Ltd. Version of Record online: 16 December 2002.
Subject Keywords:foreign exchange; anomalies; non‐stationary time series
Issue or Number:2
Classification Code:JEL: F31; G15
Record Number:CaltechAUTHORS:20190501-105813141
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Official Citation:Roll, R. and Yan, S. (2000), An explanation of the forward premium ‘puzzle’. European Financial Management, 6: 121-148. doi:10.1111/1468-036X.00117
Usage Policy:No commercial reproduction, distribution, display or performance rights in this work are provided.
ID Code:95134
Deposited By: Tony Diaz
Deposited On:01 May 2019 18:56
Last Modified:03 Oct 2019 21:10

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