Explaining the Forward Premium Puzzle

Forward Premium Puzzle refers to the widespread empirical finding that the change in the spot price of an exchange rate is negatively related to its forward premium. We propose an ambiguity-based explanation to this puzzle in which spot price moves in response to risk and ambiguity considerations of currency carry traders. The primary motivation behind this hypothesis is the inability of prior explanations based solely on a time-varying risk premium to fully account for the puzzle. We derive a tentative list of risk and ambiguity factors from extant literature and outline a procedure for evaluating their validity and explanatory power.