From Maynard and Phillips (2001) we quote: "The difference in persistence between the short-memory spot return and long-memory forward premium
does not admit a valid regression relation in returns and the slope coefficient in the Fama (1984) regression is found to converge to zero." Applying limit theory to the slope coefficient in this regression, they uncover a biased and negatively skewed distribution.
Behavioral Explanations for the Forward Premium
As a result, when a contract is renewed/rolled over during a volatility cluster, the risk due to higher volatility is often reflected in higher forward premium
, which makes hedging unattractive.
Previous explanations of the forward premium
anomaly have included peso problem effects, e.g., Evans and Lewis (1995) and the importance of learning and heterogeneous beliefs, e.g., Frankel and Froot (1987), although none of these explanations have been fully satisfactory.
Old Republic charged that Williams failed to forward premium
money and had been misusing the money in Precision's accounts.
Stock returns moved in the same direction as the BSE 200, production index, wholesale price index, dollar rate and difference in the six and three month foreign exchange forward premium
. They moved in the opposite direction to call rates, T-bill rates, gold prices, three month foreign exchange forward premium
, and differentials in long and short term interest rates.
and it is straightforward to show that the forward premium
is pinned down by the autocovariance properties of marginal utility, or equivalently by the covariance between the future short-term bond price and future marginal utility:
Because the UIP relationship is the analog to the forward premium
in the foreign exchange market, these results can be compared with those in the forward premium
where FP and DR represent the exchange rate forward premium
and the rate differential between the short term foreign and the U.S.
The latter relationship is important because the hedger can choose to exclude the forward premium
or discount from the calculation of hedge effectiveness.
Uncertainty and the forward premium
. When uncertainty is introduced, risk premiums must be accounted for.
Figure 2 compares the forward premium
with the change in the spot rate, using weekly data.