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Type: Journal article
Title: A hidden Markov approach to the forward premium puzzle
Author: Elliott, R.
Han, B.
Citation: International Journal of Theoretical and Applied Finance, 2006; 9(7):1009-1020
Publisher: World Scientific Publishing Co Pte Ltd
Issue Date: 2006
ISSN: 0219-0249
Statement of
Robert J. Elliott; Bing Han
Abstract: A Hidden Markov Chain (HMC) is applied to study the forward premium puzzle. The weekly quotient of the interest rate differential divided by the log exchange rate change is modeled as a Hidden Markov process. Compared with existing standard approaches, the Hidden Markov approach allows a detailed analysis of the puzzle on a day-to-day basis while taking into full account the presence of noise in the observations. Two and three state models are investigated. A three-state HMC model performs better than two-state models. Application of the three-state model reveals that the above quotient is mostly zero, and hence leads to the rejection of the uncovered interest rate parity hypothesis.
Keywords: Hidden Markov models
uncovered interest rate parity.
Rights: © 2006 World Scientific Publishing Company
DOI: 10.1142/S0219024906003949
Published version:
Appears in Collections:Applied Mathematics publications
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