Hostname: page-component-78c5997874-lj6df Total loading time: 0 Render date: 2024-11-10T12:27:27.807Z Has data issue: false hasContentIssue false
  • English
  • Français

LEARNING, THE FORWARD PREMIUM PUZZLE, AND MARKET EFFICIENCY

Published online by Cambridge University Press:  01 May 2009

Avik Chakraborty
Avik Chakraborty*
Affiliation:
University of Tennessee, Knoxville
*
Address correspondence to: Avik Chakraborty; e-mail: meetavik@gmail.com.
Get access Rights & Permissions [Opens in a new window]

Abstract

The Forward Premium Puzzle is widely considered to indicate inefficiency in the foreign exchange market. This paper proposes a resolution of the puzzle using recursive least squares learning. Risk-neutral agents learn the unknown parameters, underlying the exchange rate generation process, using constant-gain recursive least squares. Simulations using plausible model parameter values replicate the anomaly along with other observed empirical features of the forward and spot exchange rate data. Estimates of parameter values from data support the model assumptions and justify the use of constant-gain learning. The conclusion is that the puzzle is not necessarily a reflection of inefficiency.

Keywords

Forward Exchange RateSpot Exchange RateConstant-Gain Recursive Least Squares LearningFundamentalsStructural Change
Type
Articles
Information
Macroeconomic Dynamics , Volume 13 , Supplement S1 , May 2009 , pp. 31 - 57
Copyright
Copyright © Cambridge University Press 2009

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

REFERENCES

Andrews, Donald W.K. (1993) Tests for parameter instability and structural change with unknown change point. Econometrica 61 (4), 821–856.Google Scholar
Andrews, Donald W.K. and Ploberger, Werner (1994) Optimal tests when a nuisance parameter is present only under the alternative. Econometrica 62 (6), 1383–1414.CrossRefGoogle Scholar
Bacchetta, Philippe and van Wincoop, Eric (2006a) Can information heterogeneity explain the exchange rate determination puzzle? American Economic Review: 96 552–576.Google Scholar
Bacchetta, Philippe and van Wincoop, Eric (2006b) Incomplete Information Processing: A Solution to the Forward Discount Puzzle. Working paper, Department of Economics, Universite de Lausanne.Google Scholar
Bai, Jushan and Perron, Pierre (2003) Computation and analysis of multiple structural change models. Journal of Applied Econometrics 18, 1–22.Google Scholar
Bams, Dennis, Walkowiak, Kim, and Wolff, Christian C.P. (2004) More evidence on the dollar risk premium in the foreign exchange market. Journal of International Money and Finance 23 (2), 271–282.CrossRefGoogle Scholar
Branch, William and Evans, George W. (2006) A simple recursive forecasting model. Economics Letters 91, 158–166.Google Scholar
Brown, R.L., Durbin, J., and Evans, J.M. (1997) Techniques for testing the constancy of regression relationships over time. Econometric Exploration and Diagnosis 263–277.Google Scholar
Cavaglia, S.M.F.G., Verschoor, Willem F.C., and Wolff, Christian C.P. (1994) On the biasedness of forward foreign exchange rates: Irrationality or risk premia? Journal of Business 67 (3), 321–343.CrossRefGoogle Scholar
Chakraborty, Avik (2005) Learning and the Forward Premium Puzzle. Ph.D. dissertation, University of Oregon.Google Scholar
Chakraborty, Avik and Evans, George W. (2008) Can perpetual learning explain the forward premium puzzle? Journal of Monetary Economics, 55 (3), 477–490.Google Scholar
Cumby, Robert E. and Obstfeld, Maurice (1984) International interest rate and price level linkages under flexible exchange rates: A review of recent evidence. Exchange Rate Theory and Practice, 121–151.Google Scholar
De, Long, Bradford, J., Shleifer, Andrei, Summers, Lawrence H., and Waldmann, Robert J. (1990) Noise trader risk in financial markets. Journal of Political Economy 98 (4), 703–738.Google Scholar
Engel, Charles (1996) The forward discount anomaly and the risk premium: a survey of recent evidence. Journal of Empirical Finance 3, 123–192.CrossRefGoogle Scholar
Evans, George W. (1986) A test for speculative bubbles in the sterling-dollar exchange rate: 1981–84. American Economic Review 76 (4), 621–636.Google Scholar
Evans, George W. and Honkapohja, Seppo (2001) Learning and Expectations in Macroeconomics. Princeton, NJ: Princeton University Press.Google Scholar
Evans, Martin and Karen, K. Lewis (1993) Trends in excess returns in currency and bond markets. European Economic Review 37 (5), 1005–1019.CrossRefGoogle Scholar
Fama, Eugene F. (1984) Forward and spot exchange rates. Journal of Monetary Economics 14 (3), 319–338.Google Scholar
Frankel, Jeffrey A. and Froot, Kenneth A. (1989) Forward discount bias: Is it an exchange rate premium? Quarterly Journal of Economics 104 (1), 139–161.Google Scholar
Froot, Kenneth A. and Thaler, Richard H. (1990) Anomalies: Foreign exchange. Journal of Economic Perspectives 4 (3), 179–192.CrossRefGoogle Scholar
Hansen, Bruce E (1992) Testing for parameter instability in linear models. Journal of Policy Modeling 14 (4), 517–533.CrossRefGoogle Scholar
Hodrick, Robert J. and Srivastava, Sanjay (1986) The covariation of risk premiums and expected future spot exchange rates. Journal of International Money and Finance 5, S5–S21.Google Scholar
Kim, Young S. (2006) Exchange rates and fundamentals under adaptive learning. Working paper, Department of Economics, University of North Texas.Google Scholar
Kwiatkowski, Denis, Phillips, Peter C.B., Schmidt, Peter, and Shin, Yongcheol (2003) Testing the null hypothesis of stationarity against the alternative of a unit root. Recent Developments in Time Series 1, 52–71.Google Scholar
Lewis, Karen K. (1989) Changing beliefs and systematic rational forecast errors with evidence from foreign exchange. American Economic Review 79 (4), 621–636.Google Scholar
Lewis, Karen K. (1991) Was there a “peso problem” in the U.S. term structure of interest rates: 1979–1982? International Economic Review 32 (1), 159–173.Google Scholar
Lewis, Karen K. (1995) Puzzles in international financial markets. Handbook of International Economics 3, 1913–1971.Google Scholar
Mark, Nelson C. (2001) International Macroeconomics and Finance, Theory and Econometric Methods. Ames, IA: Blackwell Publishers.Google Scholar
Mark, Nelson C. (1985) On time varying risk premia in the foreign exchange market: An econometric analysis. Journal of Monetary Economics 16 (1), 3–18.Google Scholar
Mark, Nelson C. and Wu, Yangru (1998) Rethinking deviations from uncovered interest parity: The role of covariance risk and noise. Economic Journal 108, 1686–1706.CrossRefGoogle Scholar
Mussa, Michael (1976) The exchange rate, the balance of payments and monetary and fiscal policy under a regime of controlled floating. Scandinavian Journal of Economics 78 (2), 229–248.CrossRefGoogle Scholar
Obstfeld, Maurice (1990) The effectiveness of foreign-exchange intervention: Recent experience, 1985–1988. International Policy Coordination and Exchange Rate Fluctuations, pp. 197–237. A National Bureau of Economic Research Conference Report. Chicago and London: University of Chicago Press.Google Scholar
Obstfeld, M. and Rogoff, K. (1996) Foundations of International Macroeconomics. Cambridge, MA: MIT Press.Google Scholar
Orphanides, Athanasios and Williams, John C. (2005) Imperfect knowledge, Inflation expectations, and monetary policy. In Bernanke, Ben S. and Woodford, Michael (eds.), The Inflation Targeting Debate, pp. 201–234. Chicago: NBER and the University of Chicago Press.Google Scholar
Rossi, Barbara (2006) Are exchange rates really random walks? Some evidence robust to parameter instability. Macroeconomic Dynamics 10 (1), 20–38.CrossRefGoogle Scholar
Sargent, Thomas J. (1999) The Conquest of American Inflation. Princeton, NJ: Princeton University Press.CrossRefGoogle Scholar
Stock, James H. and Watson, Mark W. (1993) A simple estimator of cointegrating vectors in higher order integrated systems. Econometrica 61 (4), 783–820.Google Scholar
Stock, James H. and Watson, Mark W. (2003) Forecasting output and inflation: The role of asset prices. Journal of Economic Literature 41 (3), 788–829.CrossRefGoogle Scholar
Taylor, Mark P. (1995) The economics of exchange rates. Journal of Economic Literature 33 (1), 13–47.Google Scholar