European and Non-European Emerging Market Currencies: Forward Premium Puzzle and Fundamentals

Abstract

The empirical literature has consistently rejected that the uncovered interest parity (UIP) theorem holds in practice, thus posing the well-known forward premium puzzle. In this study, we examine this issue for a sample of 18 emerging market currencies and, in addition, for a subsample of 6 currencies from emerging Europe. We first confirm earlier evidence for the existence of a forward premium puzzle for emerging market economies. We then extend the model with a view to exploring systematic relationships between excess returns from investments in foreign currency and country-specific economic fundamentals. Subsequently, we use this extended model to generate out-of-sample forecasts of currency returns. We also test for forecast accuracy, confirming that these forecasts are superior to naïve forecasts. Our results show that investments based on these forecasts generate considerably higher returns than alternative investment strategies. This applies in particular to our full sample of 18 emerging market currencies. For the subsample of 6 currencies from emerging Europe, profits per trade for the model-based forecasts also outperform those generated by the other investment strategies, but by a smaller margin. These results suggest that, compared with currencies of advanced countries, the smaller bias in the forward exchange rates of emerging market currencies found in the empirical literature could relate to the better predictability of currency returns for emerging market currencies.Forward bias, emerging market currencies, forecasting