The forward premium anomaly refers to the empirical finding that interest rate differentials are not a reflection of market expectations of exchange rate changes. The anomaly is the intellectual foundation for the "carry trade" strategy of borrowing in low yield currencies and investing in high yield currencies. The vast majority of studies relating to the anomaly have employed linear models to represent the relationship between the excess return from foreign currency speculation and the interest rate differential. The purpose of this study is to explore whether the application of non-linear techniques can lead to a revision of the empirical evidence relating to the anomaly.
The evidence that is presented in the dissertation supports the hypothesis that the relationship between excess returns and interest rate differentials contains both linear and non-linear components. These components tend to offset each other, thereby leading to the conclusion that a complete model is more consistent with the absence of significant excess expected returns from currency speculation.
Earlier studies have examined the profitability of currency speculation through variations of the Markowitz mean-variance optimization approach. In the presence of significant non-linear effects, portfolio optimizers based upon the first two moments of the distribution may be inadequate. This study introduces an augmented portfolio optimizer that accommodates the higher moments of the return distribution. In particular, the model introduced allows for the portfolio weights to be influenced by the kurtosis (fat-tailed property) in the return distribution. The augmented model creates profitable portfolios in a wide variety of market scenarios. This is in contrast to the linear models where periods of profitability are often followed by periods of market correction.
|Advisor:||Bilson, John F. O.|
|School:||Illinois Institute of Technology|
|School Location:||United States -- Illinois|
|Source:||DAI-A 70/08, Dissertation Abstracts International|
|Keywords:||Foreign exchange markets, Forward premium anomaly, Hyperbolic tangent function, Polynomial utility function|
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