The Fama puzzle is comparative advantage?

The forward premium anomaly in currency markets (also referred to as the forward premium puzzle or the Fama puzzle) refers to the well documented empirical finding that the domestic currency appreciates when domestic nominal interest rates exceed foreign interest rates.^[1] This is by some perceived as puzzling because one hypothesis has been that expected future change in the exchange rate between two countries is equal to the interest-rate differentials between these two countries. 

I am just now looking at foreign exchange and the idea of a forward bet on future exchange rates would be irrational. I clam here that comparative advantage causees the Fama puzzle.



Start with a simple idea. The idea is a large bank can borrow in a foreign currency, exchange for local currency and make a profit.  We would expect the local currency to appreciate over some number of these trades.

How do forward markets in currencies work?  They don't, it seems to me.  Forward currency markets assume the exchange arbitrarge is extinguished across the who curve. If this arbitrage existed over the whole term structure, then the foreign currency and the domestic currency would a homomorphic, scaled to each other by the exchange rate.  That cannot happen. The local and foreign economies do not have the same real term structures. They would end up being the same economies with dual homomorphic currencies. The condition does no exist anywhere, and comparative advanagae is reflected in the term structure of an economy.

The Euro was an invention, compared to the dollar,  that was supposed to make the two economies homomorphic so none of these arbitrages would exist, it is not nearly successful at is as the plan. They call it the Fama puzzle, why don't world currencies become homomorphic, that is be scalable at each term point by a single exchange ratio. And the answer should be that their term points do not match.  Trying to match them result in cycles, or motion. Even if the nominal safe government terms match, there is a domestic shadow banker who tracks the real term points.  It is a triple entry accounting problem, we have shadow banking uncertainty.

The Fama puzzle is not a puzzle, it is real goods exchange adjusting to currency arbitrage. If there were no Fama puzzle, there would be no trade because no one finds comparative advantage if the two economies were homomorphic. The two economies at least have to be different enough to justify sending the map. The Fama Puzzle is the Baumol process across a constricted trade channel (Krugman agglomeration theory folks).  That guy will have to give up Keynes or I will make him eat another  Nobel Banana.

In sandbox we will get another triple play. We can match buy and sell on currencies, but either there is a very long queue, or we have large bit error.  In the latter case, the large bit error is what buyers and sellers of real goods trade against.   So, on the margin, the Fama Puzzle shows up as innovative gains to the real goods traders, one way of the other. There is a change in shipments to gain the arbitrage, and that arbitrage slows way down because real goods have a lot of waits along their path.

So, behind the scenes, a currency forward market is really a real goods foreign purchase, there is no such thing a a stable forward currency market, it is a anti-tautology because currency bankers everywhere immediately extinguish their own arbitrages. Sandbox handles all this stuff quite nicely. The exception, central banking, mainly because they need triple entry accounting and do not do it right. Standard currency banking is two color S/L, automated, as per sandbox standards.

Outside of ba central banking, there should be no future currency arbitrage unless the trader can correlate currency moves with shipments, and many do just that. We see these kinds of currency swaps associated with oil deliveries and discoveries all the time. But the real goods traders almost always see them before the currency traders and extinguish the arbitrage with opposite currency bets, adjust the excess round off.

Any residual arbitrage in currency, not caused by bad central banking, will be caused by the delusion of a foreign currency trade.