NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

The Forward Premium Puzzle in a Two-Country World

Ian Martin

NBER Working Paper No. 17564
Issued in November 2011
NBER Program(s):Asset Pricing, Economic Fluctuations and Growth, International Finance and Macroeconomics

I explore the behavior of asset prices and the exchange rate in a two-country world. When the large country has bad news, the relative price of the small country's output declines. As a result, the small country's bonds are risky, and uncovered interest parity fails, with positive excess returns available to investors who borrow at the large country's interest rate and lend at the small country's interest rate. I use a diagrammatic approach to derive these and other results in a calibration-free way.

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Document Object Identifier (DOI): 10.3386/w17564

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