Funding liquidity constraints and the forward premium anomaly in a DSGE model

•The role of a funding constraint in the forward premium anomaly is analyzed.•A risk premium term is explicitly specified in the model.•Credit frictions result in uncovered interest parity deviations in our model.•Policy shocks widen the uncovered interest parity deviations to a great extent.

This paper investigates the role of a funding liquidity constraint in the forward premium anomaly by developing a two-sector, two-agent dynamic stochastic general equilibrium (DSGE) model. We show that international consumption risks are not perfectly shared owing to the presence of a funding constraint and various discount factors. We explicitly specify a risk premium term and measure it in response to negative productivity shocks, policy shocks, and exchange rate shocks. The results indicate that these shocks, especially the policy shocks, widen the uncovered interest parity deviations to a great extent. Our research is compatible with the empirical evidence that funding illiquidity led to a significant uncovered interest parity violation during the 2008-2009 financial crisis.