Forward Premium Puzzle
University of Kansas
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Financial liberalizations in recent decades have prepared the way for the rapidly increasing number of studies related to the investigations of foreign exchange market efficiency in developing economies via testing for the uncovered interest parity (UIP) condition. Chapter 1 provides a survey on this recent literature. Specifically, it attempts to answer the following question: are the economies of developing countries different from those of developed countries in the context of the UIP condition? Examining cross-country data, Bansal and Dahlquist (2000) found that the puzzling correlation between the exchange rate changes and the interest rate differentials of two countries appears less puzzling among developing countries than among developed countries. Several economists come up with new types of theoretical models that can explain the above new findings [e.g. Alvarez and Atkeson (2005), Baccheta and Wincoop (2005, 2009)]. According to these models, when inflation is low, the exchange rate adjustment tends to be slow because adjustment is costly. This is why we observe the UIP puzzle in many developed countries where inflation rates are low. In Chapter 2, we cast doubt on these claims of the models by empirically examining the cross-country data. In essence, we argue that these models appear to solve the "nominal puzzle" but cannot solve the "real puzzle" of the UIP relation. After taking account of the relative PPP effect, we observe the same degree of the real UIP puzzle in both groups of countries. The increasing international equity flows relative to bank loans or bonds constitutes a motivation to investigate a relationship of equity returns and exchange rate change. Under no-arbitrage condition, the expected returns on home equity market should equal those on the foreign equity market. This relation is known as the Uncovered Equity Party (UEP). In Chapter 3, we propose an alternative method, called the UEP Ratio and UIP Ratio, to test the UEP relation and UIP relation, respectively. Examining time-series data for ten countries with developed financial markets, we find that UIP is less puzzling than we thought. Furthermore, unlike the literature, we find that UIP holds better than UEP. In addition, the UEP regression is a biased predictor of the deviation in UEP.
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