Forward Premium Anomaly: A New Insight through Time-varying Parameter Approach

Kun Ho Kim, College of Economics and Finance, Hanyang University, South Korea

This paper employs uniform confidence bounds to investigate the forward premium anomaly, where spot currency returns are generally found to be negatively correlated with lagged interest rate differentials, or the forward premium. This violates uncovered interest rate parity which implies a positive coefficient of unity. The results here indicate remarkable variation in the time periods where the anomaly occurs and also considerable similarity in co-movements across currencies. This paper also investigates reasons for the failure of uncovered interest parity and finds that the standard fundamentals associated with the monetary model and also variables associated with time dependent risk premium contain a lot of predictive power in explaining the extent and degree of the anomaly. This is a joint work with Richard T. Baillie.

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