DP2169 | The Forward Premium Puzzle: Different Tales from Developed and Emerging Economies

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In this paper we document new results regarding the forward premium puzzle. The often found negative correlation between the expected currency depreciation and interest rate differential is, contrary to popular belief, not a pervasive phenomenon. It is confined to developed economies, and here only to states where the U.S. interest rate exceeds foreign interest rates. Furthermore, we find that differences across economies are systematically related to per capita GNP, average inflation rates, and inflation volatility. Our empirical work suggests that it is hard to justify the cross-sectional differences in the risk premia as compensation for systematic risk. Instead, country-specific attributes seem to be important in characterizing the cross-sectional dispersion in the risk premia.