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 Puzzle
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 literature.
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.
