Forward Discount Puzzle and Liquidity Effects: Some Evidence from Exchange Rates among US, Canada, and Japan

This paper empirically examines whether the interaction between foreign exchange markets and monetary markets can help to resolve the forward discount puzzle. Following the monetary models of Lucas [1990] and Fuerst [1992], we define as liquidity effects (the negative impact of monetary injection on nominal interest rates), temporary deviations from the standard Euler equation. The liquidity effect identified by these models weakens the linkage between current forward raates and expected future spot rates, and improves on the standard rational expectations model that predicts a one-to-one correspondence between the two. Using time-series of exchange rates among US, Canada, and Japan, this paper shows that the liquidity measure identified above has an impact on forward premiums, and that once the liquidity effect is taken into consideration, the unbiased prediction of the forward discount rate is recovered to some extent in a theoretically consistent manner.