Do Exchange Rate Movements Equalize Yields?

Source: Econbrowser

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 an average appreciate by 3% against the pound in order to equalize returns.

While this puzzle has largely persisted for a long time, it disappeared during and after the global financial crisis, until reappearing recently. In this blog, the authors have propounded explanations for the same. Read on to know more.

Posted by at 7:06 AM

Labels: Macro Demystified


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