Understanding the Forward Premium Puzzle: A Microstructure Approach
- (pp. 127-54)
Abstract
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 an agent wants to trade against a public information signal. So, when based on public information, the currency is expected to appreciate, there is more adverse selection associated with a sell order than with a buy order. (JEL E43, F31, G15)Citation
Burnside, Craig, Martin Eichenbaum, and Sergio Rebelo. 2009. "Understanding the Forward Premium Puzzle: A Microstructure Approach." American Economic Journal: Macroeconomics, 1 (2): 127-54. DOI: 10.1257/mac.1.2.127Additional Materials
JEL Classification
- E43 Determination of Interest Rates; Term Structure of Interest Rates
- F31 Foreign Exchange
- G15 International Financial Markets
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