Abstract
The forward puzzle is traditionally explained as the reflection of a covariance-risk premium, market friction or limits to arbitrage. Recently, Liu and Sercu (2009; henceforth LS), working on intra-ERM rates for the DEM, presented evidence consistent with career-risk considerations (portfolio managers shun assets with danger signals), or with investors otherwise assign fallen-angel status to such assets. In this paper, we test the external validity of this finding: we compare floating rates to band-regime ones, strong base currencies to weak ones, and large economies to small ones. We find that the exchange-rate regime seems to matter the least; but the bench-marking role can come from either a huge economy (the U.S.), a strong currency (Swiss Franc, Dutch Guilder), or good ratings on both counts (Japan and Germany). Consistent with the idea that these are slow-moving reputational effects, the evidence is especially present in the long-run-trend component of the forward premium. In the short-run, filtered part, other factors seem to be at work.
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