DP6399 Understanding the Forward Premium Puzzle: A Microstructure Approach
|Author(s):||Craig Burnside, Martin Eichenbaum, Sérgio Rebelo|
|Publication Date:||July 2007|
|Keyword(s):||Exchange rates, microstructure, Uncovered interest parity|
|Programme Areas:||International Macroeconomics|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=6399|
High-interest-rate currencies tend to appreciate relative to low-interest-rate currencies. We argue that adverse-selection problems between participants in foreign exchange markets can account for this `forward premium puzzle.' The key feature of our model is that the adverse selection problem facing market makers is worse when, based on public information, a currency is expected to appreciate.