Understanding the Forward Premium Puzzle: A Microstructure Approach

Craig Burnside, Martin S. Eichenbaum, Sergio Rebelo

NBER Working Paper No. 13278
Issued in July 2007
NBER Program(s):   EFG   IFM   ME

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, based on public information, a currency is expected to appreciate.

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Published: Craig Burnside & Martin Eichenbaum & Sergio Rebelo, 2009. "Understanding the Forward Premium Puzzle: A Microstructure Approach," American Economic Journal: Macroeconomics, American Economic Association, vol. 1(2), pages 127-54, July.

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