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31/07/2020
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Working papers

ESM

How puzzling is the forward premium puzzle? A meta-analysis

Download PDF: Working Paper 46

 

The study uses meta-analysis to investigate why different papers report conflicting evidence on the forward premium puzzle and finds that the puzzle is much less prevalent than commonly thought.

Authors: Diana Zigraiova (ESM), Tomas Havranek and Jiri Novak (Charles University, Prague)

 

Abstract:

A key theoretical prediction in financial economics is that under risk neutrality and rational expectations, a currency's forward rates should form unbiased predictors of future spot rates. Yet scores of empirical studies report negative slope coefficients from regressions of spot rates on forward rates, which is inconsistent with the forward rate unbiasedness hypothesis. We collect 3,643 estimates from 91 research articles and using recently developed techniques investigate the effect of publication and misspecification biases on the reported results. Correcting for these biases yields slope coefficients of 0.31 and 0.98 for developed and emerging currencies respectively, which implies that empirical evidence is in line with the theoretical prediction for emerging economies and less puzzling than commonly thought for developed economies. Our results also suggest that the coefficients are systematically influenced by the choice of data, numeraire currencies, and estimation methods. The findings can be applied to calibrating carry trade strategies for individual currencies.
 

Disclaimer: This Working Paper should not be reported as representing the views of the ESM. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the ESM or ESM policy. No responsibility or liability is accepted by the ESM in relation to the accuracy or completeness of the information, including any data sets, presented in this Working Paper.

Keywords: Forward rate bias, uncovered interest parity, meta-analysis, publication bias, model uncertainty

JEL codes: C83, F31, G14

Source: European Stability Mechanism | Working Paper Series | Volume 2020 | No 46 | July 2020 | 42 Pages
 

Copyright © European Stability Mechanism, 2020 | All rights reserved. Any reproduction, publication and reprint in the form of a different publication, whether printed or produced electronically, in whole or in part, is permitted only with the explicit written authorisation of the European Stability Mechanism.

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