Evidence of the 'forward premium puzzle' from China

An important puzzle in international finance is the well-known forward premium puzzle' (high-interest-rate currencies tend to appreciate relative to low-interest-rate currencies). We attempted to investigate the empirical issue using cointegration tests and VECM technique for Chinese RMB vs. the US dollar based on the daily data from Oct.9,2006 to Jan. 10, 2008. Considering the capital and interest rates control in Chinese financial market, we approached the forward premium puzzle from a new angle. We substituted the non-deliverable forward rate for the forward exchange rate. The empirical evidence for the entire sample period indicates that a negative link between the forward premium and the spread between RMB's and US. dollar's interest rates. We can therefore conclude that UFH does not hold in Chinese foreign exchange market. In addition to, we discovered that domestic monetary policy has little effect on RMB-US dollar exchange rate.