Forward and Spot Exchange Rates
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What they found
If the forward exchange rate were an unbiased forecast of the future spot rate, high-interest-rate currencies should depreciate by the interest differential. Fama showed the opposite in data on nine currencies from 1973 to 1982: the forward premium predicted spot changes with the wrong sign, meaning high-interest currencies tended to appreciate rather than depreciate. This 'forward premium puzzle' implies that the currency risk premium is large and moves inversely with expected depreciation, and it is the reason the carry trade exists.
What you can use
- High-interest currencies have not depreciated enough to offset their yield advantage; that is why carry has been profitable on average.
- The forward rate is a poor forecast of the future spot rate; do not read it as the market's prediction.
- The carry return is a risk premium, so it comes with the risk of sharp reversals.
Caveats
Ten years of data on a handful of major currencies; the puzzle has weakened in some later samples and among some currency pairs. Technical econometrics.
Tags: forex, carry, forward-premium-puzzle, uncovered-interest-parity
Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.