Testing forward rate unbiasedness allowing for persistent regressors

Liu, Wei; Maynard, Alex

doi:10.1016/j.jempfin.2004.05.003

Cited by 31 publications

(20 citation statements)

References 40 publications

Supporting

Mentioning

Contrasting

Order By: Relevance

“…Additional to FX data, interest rates are necessary to construct risk factors and to analyze liquidity risk premiums as well as excess returns over UIP. Thus, similar to Liu and Maynard (2005) the interest rate differential for the various currencies is computed from LIBOR interest rates, which are obtained from Datastream. LIBOR rates are converted to continuously compounded rates to allow for comparison with monthly FX log-returns, which are computed at the same point in time.…”

Section: Monthly Datamentioning

confidence: 99%

Liquidity in the Foreign Exchange Market: Measurement, Commonality, and Risk Premiums

2012

View full text Add to dashboard Cite

show abstract

Section: Monthly Datamentioning

confidence: 99%

Liquidity in the Foreign Exchange Market: Measurement, Commonality, and Risk Premiums

2012

View full text Add to dashboard Cite

show abstract

“…2 While there are potential statistical problems in these predictability regressions (mainly small sample bias and bias caused by the persistence of the forward discount), these problems usually can only explain a part of the total bias. See, for example, Stambaugh (1999), Campbell and Yogo (2006), or Liu and Maynard (2005). 3 It consists of hedge funds exploiting forward discount bias and financial institutions that provide such services to individual clients.…”

Section: Introductionmentioning

confidence: 99%

Rational Inattention: A Solution to the Forward Discount Puzzle

Bacchetta

Wincoop

2005

SSRN Journal

View full text Add to dashboard Cite

The uncovered interest rate parity equation is the cornerstone of most models in international macro. However, this equation does not hold empirically since the forward discount, or interest rate differential, is negatively related to the subsequent change in the exchange rate. This forward discount puzzle implies that excess returns on foreign currency investments are predictable. Motivated by the fact that even today only a tiny fraction of foreign currency holdings are actively managed, we investigate to what extent incomplete information processing can explain this puzzle. Two types of incompleteness are considered: infrequent and partial information processing. We calibrate a two-country general equilibrium model to the data and show that incomplete information processing can fully match the empirical evidence. It can also account for several related empirical phenomena, including that of "delayed overshooting". We also show that incomplete information processing is optimal. Predictability is largely overshadowed by uncertainty about future exchange rates, so that the welfare gain from actively managing foreign exchange positions is small and easily outweighed by a small cost of active portfolio management.

show abstract

“…However, these problems usually can only explain a part of the total bias. See, for example, Stambaugh (1999), Campbell and Yogo (2005), or Liu and Maynard (2005). 4 See the surveys by Lewis (1995) and Engel (1996), which reach this conclusion.…”

mentioning

confidence: 88%

Rational Inattention: A Solution to the Forward Discount Puzzle

Bacchetta¹,

Wincoop²

2005

View full text Add to dashboard Cite

The uncovered interest rate parity equation is the cornerstone of most models in international macro.However, this equation does not hold empirically since the forward discount, or interest rate differential, is negatively related to the subsequent change in the exchange rate. This forward discount puzzle is one of the most extensively researched areas in international finance. It implies that excess returns on foreign currency investments are predictable. In this paper we propose a new explanation for this puzzle based on rational inattention. We develop a model where investors face a cost of collecting and processing information. Investors with low information processing costs trade actively, while other investors are inattentive and trade infrequently. We calibrate the model to the data and show that (i) inattention can account for most of the observed predictability of excess returns in the foreign exchange market, (ii) the benefit from frequent trading is relatively small so that few investors choose to be attentive, (iii) average expectational errors about future exchange rates are predictable in a way consistent with survey data for market participants, and (iv) the model can account for the puzzle of delayed overshooting of the exchange rate in response to interest rate shocks.

show abstract

Testing forward rate unbiasedness allowing for persistent regressors

Cited by 31 publications

References 40 publications

Liquidity in the Foreign Exchange Market: Measurement, Commonality, and Risk Premiums

Liquidity in the Foreign Exchange Market: Measurement, Commonality, and Risk Premiums

Rational Inattention: A Solution to the Forward Discount Puzzle

Rational Inattention: A Solution to the Forward Discount Puzzle

Contact Info

Product

Resources

About