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
JEL(s): F31
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.