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Forward Discount Bias, Nalebuff's Envelope Puzzle, and the Siegel Paradox in Foreign Exchange

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  • Edlin, Aaron S.
Abstract
The bias of forward exchange rates as a predictor of future spot rates is typically explained or decomposed as (1) a risk premium and (2) a convexity term which accounts for the fact that, when there is stochastic inflation, nominal gains from forward currency speculation are higher than real ones and correspondingly losses are smaller. We use Nalebuff's envelope puzzle to explain a third source of bias which involves real profits from foreign exchange speculation. Both the "real profit" bias and stochastic inflation bias arise from convexity of g(s)=1/s and so derive from Jensen's inequality as observed by Siegel (1972).

Suggested Citation

  • Edlin, Aaron S., 2002. "Forward Discount Bias, Nalebuff's Envelope Puzzle, and the Siegel Paradox in Foreign Exchange," Berkeley Olin Program in Law & Economics, Working Paper Series qt2wc1p9pw, Berkeley Olin Program in Law & Economics.
    • Handle: RePEc:cdl:oplwec:qt2wc1p9pw
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    References listed on IDEAS

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    1. Jeremy J. Siegel, 1972. "Risk, Interest Rates and the Forward Exchange," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 86(2), pages 303-309.
    2. Sibert, Anne, 1989. "The Risk Premium in the Foreign Exchange Market," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 21(1), pages 49-65, February.
    3. Sinn, Hans-Werner, 1989. "Expected utility and the Siegel paradox," Munich Reprints in Economics 19849, University of Munich, Department of Economics.
    4. Murray C. Kemp & Hans-Werner Sinn, 2000. "A Simple Model of Privately Profitable But Socially Useless Speculation," The Japanese Economic Review, Japanese Economic Association, vol. 51(1), pages 84-94, March.
    5. Lewis, Karen K., 1995. "Puzzles in international financial markets," Handbook of International Economics, in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 37, pages 1913-1971, Elsevier.
    6. Engel, Charles M., 1984. "Testing for the absence of expected real profits from forward market speculation," Journal of International Economics, Elsevier, vol. 17(3-4), pages 299-308, November.
    7. Kenneth A. Froot & Jeffrey A. Frankel, 1989. "Forward Discount Bias: Is it an Exchange Risk Premium?," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 104(1), pages 139-161.
    8. Grauer, Frederick L. A. & Litzenberger, Robert H. & Stehle, Richard E., 1976. "Sharing rules and equilibrium in an international capital market under uncertainty," Journal of Financial Economics, Elsevier, vol. 3(3), pages 233-256, June.
    9. Hansen, Lars Peter & Hodrick, Robert J, 1980. "Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis," Journal of Political Economy, University of Chicago Press, vol. 88(5), pages 829-853, October.
    10. J. Huston McCulloch, 1975. "Operational Aspects of the Siegel Paradox," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 89(1), pages 170-172.
    11. Nalebuff, Barry, 1989. "The Other Person's Envelope Is Always Greener," Journal of Economic Perspectives, American Economic Association, vol. 3(1), pages 171-181, Winter.
    12. Tiff Macklem, R., 1991. "Forward exchange rates and risk premiums in artificial economies," Journal of International Money and Finance, Elsevier, vol. 10(3), pages 365-391, September.
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    Cited by:

    1. Keivan Mallahi-Karai & Pedram Safari, 2018. "Future exchange rates and Siegel's paradox," Papers 1805.03347, arXiv.org.
    2. Mallahi-Karai, Keivan & Safari, Pedram, 2018. "Future exchange rates and Siegel's paradox," Global Finance Journal, Elsevier, vol. 37(C), pages 168-172.

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