Resolving the Unbiasedness and Forward Premium Puzzles
There are two unresolved puzzles in the empirical foreign exchange literature. The first is the finding that tests of forward rate unbiasedness using the forward rate and forward premium equations yield markedly different conclusions. A companion puzzle—the forward premium puzzle—is the fact that the forward premium incorrectly predicts the direction of the subsequent change in the spot rate, which implies a massive rejection of uncovered interest parity. This paper resolves both puzzles.