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Title: Understanding Forward Premium Puzzle: A Risk-Based Approach
Authors: Palwishah, Rana Imroze
Keywords: Bussiness & Management
Management Studies
Issue Date: 2020
Publisher: Shaheed Zulfikar Ali Bhutto Institute of Sciences & Technology, Karachi.
Abstract: Uncovered interest rate parity (UIP) is crucial in international finance and macro-economics, widely used in constructing models and their analytical work. However, empirical regularities in UIP, referred to as the "Forward Premium Puzzle," has posed a significant challenge to open economy models. Thus to understand the forward premium puzzle, the study proposes an extensive extreme risk framework that distinguishes between country-specific and (global components) and empirically tests this framework on a sample of 20 developed countries' currencies from 1990 to 2017. The results showed that currencies with the highest beta, co kurtosis, downside co-skewness, and interest rate differential yield a premium that exceeds its counterpart. Therefore, they indicate that asymmetry plays an essential role in how the investors view risk in a foreign exchange market. Motivated by the significance of extreme risk factors, the study used consumption, equity, and bond risk factors to explain the asymmetric currency returns variation. However, bond risk factors outperform consumption and equity risk factors in explaining sensitivity in cross-section of excess currency returns with maturity risk and default risk giving the highest incentive for downside co-skewness currency returns. Moreover, considering the plethora of literature on liquidity, exploring its presence in extreme market conditions, the study also examines whether risk-averse investors in the foreign exchange market receive compensation for asymmetric liquidity risk. The results show that aggregate extreme liquidity, extreme liquidity sensitivity to market returns, and commonality in extreme liquidity risk are priced effectively in asymmetric currency returns. Thus, they confirm the essential role of extreme risk in a foreign exchange market, suggesting that assuming liquidity risk in symmetric representation may undervalue the importance of currency return risk.
Gov't Doc #: 22226
Appears in Collections:PhD Thesis of All Public / Private Sector Universities / DAIs.

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