Forward Premium Anomaly of the British Pound and the Euro

Document Type

Article

Publication Date

7-2014

Publication Title

International Review of Financial Analysis

DOI

10.1016/j.irfa.2014.05.013

Abstract

Using pooled data, we study the forward discount bias (FDB) of 24 British pound and 24 euro exchange rates. The results show a FDB during “non-crisis” periods, which is more pronounced for advanced than emerging economies. This finding is especially striking during the period of the European sovereign debt crisis (2010 to 2013), for which we find a FDB for the currencies of advanced economies versus the pound, but not versus the euro. The differences between the results for advanced and emerging country currencies are mainly related to whether the period under investigation is classified as a crisis period or not. Our findings support the literature that relates carry trade activities to the FDB; as such activities are assumed to decrease during times of uncertainty. Further, our study shows evidence for asymmetric behavior with respect to the forward premium, as well as, to the overvaluation and undervaluation of the currency. We find negative slope coefficients for advanced country currencies during crisis periods when the pound and the euro are overvalued and sell at a premium. This suggests that even during crisis periods carry trade activities are present, which may be related to investors' assumptions of higher returns when an overvalued pound or euro is expected to move back to equilibrium.

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