DP6399 | Understanding the Forward Premium Puzzle: A Microstructure Approach

Publication Date

20/07/2007

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Abstract

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.