The forward premium anomaly and the currency carry trade hypothesis

Abstract

In this paper, we examine whether the currency carry trade hypothesis can consistently explain the forward premium bias (anomaly) across different regimes of interest rates differentials. To investigate this, we consider a nonlinear extension of the forward premium regression allowing for interest rates differentials threshold effects. Using the US dollar as home currency, we provide clear-cut evidence that the currency carry trade hypothesis can offer an explanation of the forward premium anomaly only when interest rates differentials are positive. When they are negative, or close to zero, the hypothesis fails to explain the forward premium anomaly. We show that the negative interest rates differentials regime covers periods of financial crises and distressed market conditions which may lead investors to seek safe-haven currencies and thus, adopt anti-carry trade strategies.