Author Archives: Menzie Chinn

Do Exchange Rate Movements Equalize Yields?

Fama (JME, 1984), and Tryon (1979) demonstrated that changes in the exchange rate  do not equal the forward premium, in what came to be known as the forward premium puzzle. Since the forward premium equals the interest differential in the absence of current and incipient capital controls and in the absence of default risk —  this finding is equivalent to the result that interest rates, after accounting for exchange rate changes, are not equalized on average.

In other words, if the yield on the US default-risk-free bond is 2% and the yield on a UK default-risk-free bond is 5%, then the US dollar does not on average appreciate by 3% against the pound in order to equalize returns. This finding could be explained, for instance, by the presence of a time-varying exchange risk premium on pound sterling assets (vs. dollar assets); however, it’s not been easy to find robust evidence of determinants of such a time varying premium.

While this puzzle has largely persisted in the ensuing 25 years, it seemingly disappeared during and after the global financial crisis — until re-appearing in recent years.

Continue reading