Accounting for Forward Rates in Markets for Foreign Currency

Authors

  • DAVID K. BACKUS,

  • ALLAN W. GREGORY,

  • CHRIS I. TELMER

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    • Stern School of Business, New York University, Queen's University, and Carnegie Mellon University, respectively. We thank Geert Bekaert, Philip Dybvig, Wayne Person, Campbell Harvey, Dennis Logue, Thomas McCurdy, James Nason, Thomas Pugel, Gregor Smith, Stanley Zin, and especially Ravi Jagannathan for helpful comments and suggestions, as well as the editor, René Stulz, and a referee of this journal. Financial support from the National Science Foundation, the Social Sciences and Humanities Research Council of Canada, and the Center for Japan-U.S. Business and Economic Studies faculty fellowship program is gratefully acknowledged.


ABSTRACT

Forward and spot exchange rates between major currencies imply large standard deviations of both predictable returns from currency speculation and of the equilibrium price measure (the intertemporal marginal rate of substitution). Representative agent theory with time-additive preferences cannot account for either of these properties. We show that the theory does considerably better along these dimensions when the representative agent's preferences exhibit habit persistence, but that the theory fails to reproduce some of the other properties of the data—in particular, the strong autocorrelation of forward premiums.

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