The puzzle that just isn't

TL;DR

This paper critically examines the forward premium puzzle, arguing it may not exist in its traditional form, by analyzing interest rate, exchange rate, and inflation behaviors and proposing alternative explanations.

Contribution

It challenges the existence of the canonical forward premium puzzle and offers a reinterpretation based on market behaviors and alternative explanations.

Findings

The forward premium puzzle does not hold in its canonical form.

Interest rate, exchange rate, and inflation behaviors can be explained without the puzzle.

Alternative explanations better account for observed market facts.

Abstract

In his stimulating article on the reasons for two puzzling observations about the behaviour of interest rates, exchange rates and the rate of inflation, Charles Engel (2016) puts forward an explanation that rests on the concept of a non-pecuniary liquidity return on assets. Albeit intriguing the analysis struggles to account for a number of facts which are familiar to participants of the foreign exchange and bond markets. Reconciling these facts in conjunction with a careful dissection of the "puzzle" to begin with, shows that the forward premium puzzle just does not exist, at least not in its canonical form.