Risk Premiums and the Forward Rate Anomaly: A Survey

Financial economists have intensely scrutinised whether forward currency markets reflect all relevantinformation. In a no-arbitrage environment, the twin assumptions of risk neutrality and rational expectations implythat the forward rate should be an unbiased predictor of realised future spot rates. This has been labeled the UnbiasedForward Rate Hypothesis (UFRH). Unfortunately, empirical support for the UFRH is unconvincing. Estimatedcoefficients are frequently of the wrong sign as predicted by theory. This empirical regularity has been termed, amongothers, the forward rate puzzle. Many have attempted to reconcile these anomalous findings with the EfficientMarkets Hypothesis (EMH) – the notion of a market that impounds all relevant information into prices. However, acompletely satisfactory explanation remains elusive. This paper aims to review how researchers have attempted toexplain the forward rate puzzle, with particular emphasis upon how currency markets may inherently attract riskpremiums, and how they may vary over time. Moreover, we examine Keynes’ proposition that inspired the insurancetheory of speculation. This line of reasoning suggests that speculators are systematically rewarded for participating inmarkets. Although dated, interest in Keynes’ proposition remains. Subsequent research has found that speculatorsreceive compensation for their actions. Furthermore, it is noted that relatively few have attempted to combine theinsurance theory of speculation with the forward rate puzzle. Given the attention attributed to speculators in today’sfinancial 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.