Indian Journal of Finance

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Forward Premium Anomaly and Risk Premiums in the Currency Markets: A Literature Review


Affiliations
1 Faculty, Department of Finance, IBS Hyderabad, The ICFAI Foundation for Higher Education, Survey Number 156/157, Dontanpally Village, Shankarpally Mandal, R.R. District, Hyderabad- 501 203, India
2 Faculty, Department of Finance, IBS Hyderabad, The ICFAI Foundation for Higher Education, Survey Number 156/157, Dontanpally Village, Shankarpally Mandal, R.R. District, Hyderabad-501 203, India

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The uncovered interest rate parity (UIP) is one of the most important theories explaining the relationship between the currency spot and futures rate. UIP states that under the assumption of rational expectations, the futures rate should be an unbiased predictor of the future spot rate. However, there is a vast literature that suggests that the UIP is empirically violated, and this condition is called forward premium anomaly. The forward premium anomaly is a condition when the forward rate is not an unbiased predictor of the future spot rate. One of the main reasons for the forward premium anomaly has been attributed to the presence of time-varying risk premiums. Prior studies have not been successful in addressing the issue of forward premium anomaly in the currency markets. In this paper, we presented an overview of the existing literature which explains the forward premium anomaly and the risk premium.

Keywords

Currency Futures Markets, Forward Premium, Risk Premiums, Unbiasedness

F31, G13, G15

Paper Submission Date : September 22, 2013 ; Paper sent back for Revision : March 3, 2014 ; Paper Acceptance Date : April 4, 2014

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  • Forward Premium Anomaly and Risk Premiums in the Currency Markets: A Literature Review

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Authors

Satish Kumar
Faculty, Department of Finance, IBS Hyderabad, The ICFAI Foundation for Higher Education, Survey Number 156/157, Dontanpally Village, Shankarpally Mandal, R.R. District, Hyderabad- 501 203, India
Rajesh Pathak
Faculty, Department of Finance, IBS Hyderabad, The ICFAI Foundation for Higher Education, Survey Number 156/157, Dontanpally Village, Shankarpally Mandal, R.R. District, Hyderabad-501 203, India
Ranajee
Faculty, Department of Finance, IBS Hyderabad, The ICFAI Foundation for Higher Education, Survey Number 156/157, Dontanpally Village, Shankarpally Mandal, R.R. District, Hyderabad- 501 203, India

Abstract


The uncovered interest rate parity (UIP) is one of the most important theories explaining the relationship between the currency spot and futures rate. UIP states that under the assumption of rational expectations, the futures rate should be an unbiased predictor of the future spot rate. However, there is a vast literature that suggests that the UIP is empirically violated, and this condition is called forward premium anomaly. The forward premium anomaly is a condition when the forward rate is not an unbiased predictor of the future spot rate. One of the main reasons for the forward premium anomaly has been attributed to the presence of time-varying risk premiums. Prior studies have not been successful in addressing the issue of forward premium anomaly in the currency markets. In this paper, we presented an overview of the existing literature which explains the forward premium anomaly and the risk premium.

Keywords


Currency Futures Markets, Forward Premium, Risk Premiums, Unbiasedness

F31, G13, G15

Paper Submission Date : September 22, 2013 ; Paper sent back for Revision : March 3, 2014 ; Paper Acceptance Date : April 4, 2014




DOI: https://doi.org/10.17010/ijf%2F2014%2Fv8i12%2F71692