The Role of Uncertainty in the Forward Premium Puzzle: Evidence from the Foreign Exchange Market

This thesis aims to study the importance and impact of financial, macroeconomic and policy uncertainties on the Excess Return generated by the misalignment of the UIP in the Foreign Exchange (FX) market. Recent academic literature is assigning increasing importance to uncertainty dynamics in the Forward Premium Puzzle, identifying the role of sentiment and beliefs as the principal drivers determining the future exchange rate in short- to medium-term movements. On this track, the uncertainty can act as driver increasing gains of foreign risky currencies through increasing their risk premium or decreasing their values through an excess of expected devaluation. To verify this, the uncertainty series obtained from the works of Jurado, Ludvigson and Ng (2015), Baker, Bloom, and Davis (2016) and Caldara, Iacoviello, Molligo, Prestipino and Raffo (2019) will be used, as they adopt different approaches to capture the level of turbulence. Secondly, a Cholesky Vector Autoregression (VAR) will be adopted to verify the impact of shocks on Excess Returns generated by the difference between the realized future Spot Exchange Rate and the current Forward Exchange Rate contracted for the same maturity. The analysis will show a general negative effect on the excess return against foreign currencies in favour to dollar contributing to the deviation from UIP, following the founds Della Corte, Krecetosvs (2015) meaning that even when a foreign currency offers a higher remuneration compared to the USD during uncertainty periods, the temporary excess return will be lower due to the expected future devaluation. Different exchange rate adjustment patterns will be identified as highlighted by Wang (2013). These patterns vary depending on the specific type of uncertainty index considered.