DP7772 The Forward Premium Puzzle and Latent Factors Day by Day

Author(s): Kerstin Bernoth, Casper G de Vries, Jürgen von Hagen
Publication Date: April 2010
Keyword(s): forward premium puzzle, futures rates, latent factor
JEL(s): F31, F37, G13
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=7772

We use futures instead of forward rates to study the complete maturity spectrum of the forward premium puzzle from two days to six months. At short maturities, the slope coefficient is positive, but it turns negative as the maturity increases to the monthly level. Futures data allow us to control for the influence of an unobserved factor that can be decomposed into a contract-specific and a time-to-maturity effect. Once we do this, we find that the coefficients on the forward premium are much closer to one. The latent factor is shown to be related to conventional proxies of risk.