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This paper focuses on two actively studied inefficiencies in financial markets: the
forward premium bias in foreign exchange markets (see, for example, Hansen and
Hodrick 1980, Fama 1984, Bansal and Dahlquist 2000, etc.) and the empirical finding
that the time expectations theory performs relatively poorly in describing the average
shape of yield curves (for a list of papers see, for example, Backus et al. 1998, p 1).
The goal of the article is to test whether these two inefficiencies can still offer the
possibilities of earning positive and stable excess return for investors. For that
purpose, first two very simple trading strategies are tested based on the
abovementioned inefficiencies: buying the currencies of the countries with higher
short-term interest rates against the currencies of the countries with lower short-term
interest rates (i.e. simple FX carry-strategy) and holding long-only positions in longerterm
interest rate futures.
The results show that the two studied risk premiums are still present in the markets
and enable investors to earn excess returns even with simple strategies. Additional
tests show that the performance of these simple strategies can be further improved by
the inclusion of a risk factor in the foreign exchange carry-strategy and by the addition
of monetary policy direction and yield curve steepness filters in the long-only strategy
in interest rate futures.
JEL Code: E44, E47, E58, F37, G11, G15
Key words: trading rules, forward premium bias, time expectations theory
Author's e-mail address: vesilind@epbe.ee
The views expressed are those of the author and do not necessarily represent the official views of Eesti Pank.
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