Forward Premium Anomaly Resolved

Abstract

This paper propounds that the Forward Premium Anomaly (FPA) arises due to misspecification in the extant empirical models, where ratios of the concerned variables are studied instead of their levels themselves. We study these variables directly instead of their ratios for 22 currency pairs from both developed and emerging economies and find that the FPA stands resolved for the short-term tenors of weekly and monthly durations. We further conduct tests of cointegration between the dependent and the explanatory variables for the levels and report evidence of cointegration between the variables indicating that their regressions reflect valid relationships.