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Uncovered interest parity and the forward premium puzzle : implications for market efficiency and carry trade

Ullenes, Bengt Terje
Master thesis
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URI
http://hdl.handle.net/11250/169981
Date
2012
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  • Master Thesis [3346]
Abstract
Uncovered interest parity is a fundamental concept in foreign exchange and implies that the

same deposit placed at home or abroad should yield equal returns. The forward premium

puzzle refers to a well known empirical failure of the uncovered interest parity relation. Under

the forward premium puzzle, currencies that are expected to depreciate, in fact tend to

appreciate.

This puzzling fact have been interpreted as a failure of the efficient market hypothesis in the

foreign exchange market, and has served as a theoretical foundation for earning excess returns

from the currency speculation known as carry trade. According to uncovered interest parity,

no excess return from such speculation should be possible.

This thesis tests for the appearance of the forward premium puzzle in recent data through the

conventional approach of regressing the change in spot prices on the forward premium. In

addition, two excess return based trading strategies are analyzed as a more practical and direct

approach to testing the efficient market hypothesis and uncovered interest parity.

My findings regarding the puzzle are consistent with existing literature in the sense that the

forward premium puzzle is identified for all eight currency pairs which are included in the

regression. However, the estimated coefficients are statistically insignificant, and it is

therefore difficult to draw definitive conclusions from the analysis.

On the other hand, results from testing the excess return based strategies shows that the

apparent presence of the forward premium puzzle not necessarily indicates that there are

excess return possibilities in the foreign exchange market. Excess return is only identified for

the Norwegian krone and Australian dollar against US dollar parities, but test results remain

inconclusive due to violations of the conditions under the ordinary least squares methodology

in regression analysis.

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