Testing the Persistence of the Forward Premium: Structural Changes or Misspecification?

Abstract

This study investigates whether the ignored structural break causes the forward premium non-stationary. This paper proposes to test for the presence of unit root with multiple structural breaks. We find that, as long as the dynamic lag structure is specified, the forward premium exhibits a non-stationary process even if structural breaks are accounted for and points to no evidence of moving toward stationarity. Given our findings, the structural change model seems less robust in explaining the forward premium puzzle.

The existence and severity of the forward premium puzzle during tranquil and turbulent periods: Developed versus developing country currencies

“…2016Sarno, 2005;Chinn, 2006;Jongen et al, 2008). Generally speaking, the explanations provided can be classified into four categories where the FPB can be attributed to: first, the existence of time-variant risk premium component in forward rates (e.g., Hodrick and Srivastava, 1986;Frankel and Chinn;1993, Verdelhan, 2010Kumar, 2020;Abankwa and Blenman;2021), second, the existence of systematic errors in market participants' expectations of future currency values (e.g., Lewis, 1989;Froot and Frankel 1989;Engel and Hamilton, 1990;Kaminsky, 1993;Yu, 2013), third, the existence of statistical and econometrical issues in the UH test regression equation (e.g., Baillie and Bollerslev, 2000;Baillie and Kilic, 2006;Gospodinov, 2009;Pippenger, 2011;Ho and Mo, 2016) and fourth, the effects of currency trading strategies which attempt to exploit the bias in forward rates (e.g., Gagnon and Chaboud, 2007;Bacchetta and Wincoop, 2010;Hochrald and Wagner, 2010;Plantin and Shin, 2011;Spronk et al, 2013;Breedon et al, 2016;Cho et. al., 2019;Czech, 2020).…”