Risk Premiums and the Forward Rate Anomaly: A Survey

Abstract: Financial economists have intensely scrutinised whether forward currency markets reflect all relevant information. In a no-arbitrage environment, the twin assumptions of risk neutrality and rational expectations imply that the forward rate should be an unbiased predictor of realised future spot rates. This has been labeled the Unbiased Forward Rate Hypothesis (UFRH). Unfortunately, empirical support for the UFRH is unconvincing. Estimated coefficients are frequently of the wrong sign as predicted by theory. This empirical regularity has been termed, among others, the forward rate puzzle. Many have attempted to reconcile these anomalous findings with the Efficient Markets Hypothesis (EMH) – the notion of a market that impounds all relevant information into prices. However, a completely satisfactory explanation remains elusive. This paper aims to review how researchers have attempted to explain the forward rate puzzle, with particular emphasis upon how currency markets may inherently attract risk premiums, and how they may vary over time. Moreover, we examine Keynes ’ proposition that inspired the insurance theory of speculation. This line of reasoning suggests that speculators are systematically rewarded for participating in markets. Although dated, interest in Keynes ’ proposition remains. Subsequent research has found that speculators receive compensation for their actions. Furthermore, it is noted that relatively few have attempted to combine the insurance theory of speculation with the forward rate puzzle. Given the attention attributed to speculators in today’s financial markets, such a consideration is highly important in unraveling the mysteries of modern currency markets, particularly given the tumultuous world environment of the recent past