An Explanation of the Forward Premium Puzzle: The Long and the Short of It

Abstract

The forward premium anomaly, i.e., the empirical evidence that exchange rate changes are negatively related to interest rate differentials, is one of the most robust puzzles in financial economics. We add to this literature by recasting the underlying parity relation in terms of cross-country differences between forward interest rates rather than spot interest rates. The differences using spot and maturity-matched forward rates are dramatic. As the maturity of the forward interest rate differential increases, the anomalous sign on the coefficient in the traditional specification is reversed, and the explanatory power increases. We present a simple model of interest rates, inflation, and exchange rates that explains this novel empirical evidence. The model is based on interest rate distortions due to Taylor rules and exchange rate determination involving not just purchasing power parity, but also effects due to real rate differentials and subsequent reversion of the exchange rate to fundamentals. We develop and test additional implications of this model. A key finding is that the effect of current interest rate differentials on exchange rates can be decomposed into two offsetting components, which, if used separately, greatly increase the explanatory power of regression models for exchange rates.hry 2451/25922hry 2451/25922