Affine Term Structure Models and the Forward Premium Anomaly

Authors: Backus, David K.¹; Foresi, Silverio²; Telmer, Chris I.³

Source: The Journal of Finance, Volume 56, Number 1, February 2001 , pp. 279-304(26)

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Abstract:

One of the most puzzling features of currency prices is the forward premium anomaly: the tendency for high interest rate currencies to appreciate. We characterize the anomaly in the context of affine models of the term structure of interest rates. In affine models, the anomaly requires either that state variables have asymmetric effects on state prices in different currencies or that nominal interest rates take on negative values with positive probability. We find the quantitative properties of either alternative to have important shortcomings.

Document Type: Original article

DOI: http://dx.doi.org/10.1111/0022-1082.00325

Affiliations: 1: Stern School of Business, New York University and the National Bureau of Economic Research, 2: Goldman Sachs, 3: Graduate School of Industrial Administration, Carnegie Mellon University

Publication date: 2001-02-01