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American Economic Journal: Macroeconomics: Vol. 1 No. 2 (July 2009)

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Understanding the Forward Premium Puzzle: A Microstructure Approach

Article Citation

Burnside, Craig, Martin Eichenbaum, and Sergio Rebelo. 2009. "Understanding the Forward Premium Puzzle: A Microstructure Approach." American Economic Journal: Macroeconomics, 1(2): 127-54.

DOI: 10.1257/mac.1.2.127

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 an agent wants to trade against a public information signal. So, when based on public information, the currency is expected to appreciate, there is more adverse selection associated with a sell order than with a buy order. (JEL E43, F31, G15)

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Authors

Burnside, Craig (Duke U)
Eichenbaum, Martin (Northwestern U)
Rebelo, Sergio (Northwestern U)

JEL Classifications

E43: Determination of Interest Rates; Term Structure of Interest Rates
F31: Foreign Exchange
G15: International Financial Markets

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American Economic Journal: Macroeconomics


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