New Evidence on the Forward Premium Puzzle

The forward premium anomaly (exchange rate changes are negatively related to interest rate differentials) is one of the most robust puzzles in financial economics. We recast the underlying parity relation in terms of lagged forward interest rate differentials, documenting a reversal of the anomalous sign on the coefficient in the traditional specification. We show that this novel evidence is consistent with recent empirical models of exchange rates that imply exchange rate changes depend on two key variables: the interest rate differential and the magnitude of the deviation of the current exchange rate from that implied by purchasing power parity.