The forward premium anomaly is not as bad as you think

By Richard T. Baillie, Tim Bollerslev. 2000

331 citations recorded by the source corpus.

Abstract The forward premium anomaly refers to the widespread empirical finding that the slope coefficient in the regression of the change in the logarithm of the spot exchange rate on the forward premium is invariably less than unity, and often negative. This “anomaly” implies the apparent predictability of excess returns over uncovered interest rate parity (UIP), and is conventionally viewed as evidence of a biased forward rate and/or of evidence of a time-varying risk premium. This paper presents a stylized model that imposes UIP and allows the daily spot exchange rate to possess very persistent volatility. The model is calibrated around realistic parameter values for daily returns and the slope coefficient estimates in the anomalous regressions with monthly data are found to be centered around unity, but are very widely dispersed, and converge to the true value of unity at a very slow rate. This theoretical evidence is shown to be consistent with the empirical findings for the monthly sample sizes typically employed in the literature. Hence, the celebrated unbiasedness regression does not appear to provide as much evidence as previously supposed concerning the possible bias of the forward rate.

Subfields: Economics and Econometrics, Finance

View Paper: https://www.semanticscholar.org/paper/a882dedc0db55fd00cbf1f0539efd2bf9e5fecae

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Citations in the corpus

Uncovered Interest Rate Parity and the Term Structure (2002, background): “…evidence has not stopped theorists from relying on UIRP, it is fortunate that recent evidence is more favorable: Bekaert and Hodrick (2001) and Baillie and Bollerslev (2000) argue that doubtful statistical inference may have contributed to the strong rejections of UIRP at higher frequencies…”
Do Asymmetric and Nonlinear Adjustments Explain the Forward Premium Anomaly (2006, background): “These issues are analyzed by Baillie and Bollerslev (2000) and Maynard and Phillips (2001).”
Exchange Rate Predictability (2013, unknown): “…a time-varying risk premium (Fama, 1984; Backus, Foresi and Telmer, 2001); estimation biases (Bekaert and Hodrick, 2001); imprecise standard errors (Baillie and Bollerslev, 2000, Rossi, 2007a); and small samples (Chinn and Meredith, 2004, who nd positive evidence in longer samples, and Chen and…”
Uncovered Interest Rate Parity Over the Past Two Centuries (2011, background): “In related literature, Baillie and Bollerslev (2000), Bekaert and Hodrick (2001), and Bekaert et al. (2007) show how small sample can bias the regression tests to overwhelmingly reject the expectation hypothesis even when it holds. Lewis (1989), Gourinchas and Tornell (2004), and Bacchetta and van W”
Testing Long-Horizon Predictive Ability with High Persistence, and the Meese-Rogoff Puzzle (2005, unknown): “Other recent works related to the present paper are Baillie and Bollerslev (2000) and Maynard and Phillips (2001), who suggest that another well-known empirical puzzle in international economics (the forward discount anomaly) might be explained by persistent variance or long memory.”
The (partial) rehabilitation of interest rate parity in the floating rate era: Longer horizons, alternative expectations, and emerging markets (2006, background): “In addition, it does not focus primarily on time series concerns that recast the results regarding the unbiasedness hypothesis, such as those by Baillie and Bollerslev (2000), Zivot (2000) and Maynard and Phillips (2001).”
Rethinking an old empirical puzzle: econometric evidence on the forward discount anomaly (2001, methodology): “This follows the empirical evidence presented both here and in Baillie and Bollerslev (1994). The spot rate is modelled as a unit root process in (III), an assumption which is by now non-controversial, and the forward rate is defined implicitly by CIP in (I).”
Risk and return: Long-run relations, fractional cointegration, and return predictability $ (2013, methodology): “This same statistical problem has also previously been discussed in the context of regression-based tests for unbiasedness in the forward foreign exchange market by Baillie and Bollerslev (2000).”
Crash-Neutral Currency Carry Trades (2014, unknown): “C̃T t+1 = { rf,t > rd,t : exp (rf,t · τ) · S̃t+τ − exp (rd,t · τ) · St rd,t > rf,t : exp (rd,t · τ) · St − exp (rf,t · τ) · S̃t+τ (4)”
The risk return tradeoff in the long run: 1836–2003 (2007, unknown): “In the exchange rate literature, Baillie and Bollerslev (2000) have demonstrated that extreme caution should be exercised when interpreting projection coefficients under these conditions.”
Nonlinearity in Deviations from Uncovered Interest Parity: An Explanation of the Forward Bias Puzzle (2006, unknown): “This modelling strategy is also consistent with the evidence of parameter instability reported in Baillie and Bollerslev (2000), providing a rationale for the result of instability of the parameter β over time: under the working hypothesis of nonlinearity induced by limits to speculation, β is a…”
Uncovered interest parity: it works, but not for long (2003, unknown): “Nor is it consistent with the usual rejection of the UIP hypothesis being an artifact of difficulties in statistical inference (as discussed by Baillie and Bollerslev (2000), among others).”
Long Memory and Structural Changes in the Forward Discount: An Empirical Investigation (2007, methodology): “Engel (1996) summarized four explanations: (1) existence of a foreign exchange risk premium; (2) a peso problem, (3) irrational expectations; (4) international financial market inefficiency from various frictions.”
Variance Risk Premiums and the Forward Premium Puzzle (2012, unknown): “The classification is done according to the As for the currency-specific regressions, this setup might be subject to the inference problems documented by Baillie and Bollerslev (2000)”
The Forward Premium Puzzle: Different Tales from Developed and Emerging Economies (2000, methodology): “Recent results provided by Baillie and Bollerslev (1997) show that great caution should be exercised in interpreting the univariate results as documented in Table 4. They argue that as the interest rate differential is very persistent, the standard asymptotic distribution for the slope-coefficient”
Macroeconomic Determinants of Carry Trade Activity (2012, unknown): “References [1] Baillie, R.”