Reexamination of Forward Premium Anomaly in Foreign Exchange Markets Allowing for Realized Volatility and Jump Process

By using the daily Euro-Dollar and Yen-Dollar spot and overnight forward exchange rates, this paper reexamines the issue of the forward premium anomaly which has attracted widespread attention in international finance. In particular, this paper investigates a statistical evidence for the role of realized volatility and jump process in the tests of the anomaly, which have mostly ignored in the previous studies. For the purpose, this paper adjusts the usual regression model of testing the forward premium anomaly by allowing for realized volatility and jump process. After reestimating the adjusted regression model, this paper finds that the estimated value of the forward premium coefficient in the Yen-Dollar currency market is positive while the coefficient in the Euro-Dollar currency market is still negative yet reduced significantly. Thus, this paper presents the possibility that the empirical phenomenon of the forward premium anomaly in foreign exchange markets may not be as robust as the previous studies have presented if the regression models used in those studies are specified more appropriately by allowing for the realized volatility and the jump process.