Presentation: Solving the "Forward-Premium Puzzle" of Finance
Abstract: Macroeconomic and financial aggregate series have been shown empirically to share an unconventional form of cyclical and persistent dynamics, whose functional form was obtained from the solution of general-equilibrium models with heterogeneous firms (Abadir and Talmain, Review of Economic Studies 2002; Abadir, Caggiano, and Talmain, J Econometrics 2013). Equations linking such series are modelled incompletely by existing techniques, causing paradoxical regression results and omitting predictabilities. We provide a solution to disentangle the genuine relation between variables from these dynamics and we apply it to model exchange-rate dynamics.
We show that GBPUSD forward premia have no predictive power for excess returns (thus solving this forward-premium puzzle) once the unconventional dynamics of spot rates are modelled. Taking advantage of these dynamics, we uncover a trading strategy that consistently outperforms existing ones throughout 1977-2013. Hence, even in this heavily traded market, the Efficient Market Hypothesis has been failing for over 37 years because traders could not work out the dynamics of the spot rate.
Fall quarter seminar organizers: Bulat Gafarov and Dalia Ghanem