The Forward Premium Puzzle in a Two-Country World
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.
I am grateful to Fernando Alvarez, Dave Backus, Thomas Baranga, John Cochrane, Darrell Due, Bernard Dumas, Lars Hansen, Bruce Lehmann, Robert Lucas, Monika Piazzesi, Roberto Rigobon, Martin Schneider, Nancy Stokey, and Harald Uhlig, and to seminar participants at Central European University, the University of Chicago, the Stanford Institute for Theoretical Economics conference, Stanford GSB, and UCSD for their comments. The views expressed herein are those of the author and do not necessarily reflect the views of the National Bureau of Economic Research.