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Structural change in the forward discount: Implications for the forward rate unbiasedness hypothesis

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  • Sakoulis, Georgios
  • Zivot, Eric
  • Choi, Kyongwook
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    Abstract

    It is a well-accepted empirical result that forward exchange rate unbiasedness is rejected in tests using the "differences regression" of the change in the logarithm of the spot exchange rate on the forward discount. We model the forward discount as an AR(1) process and argue that its persistence is exaggerated due to the presence of structural breaks. We show using a stochastic multiple break model that the forward discount persistence is substantially less if one allows for multiple structural breaks in the mean of the process. We argue that these breaks could be identified as monetary shocks to the central bank's reaction function. Using Monte Carlo simulations, we show that if we do not account for structural breaks that are present in the forward discount process, the forward discount coefficient in the "differences regression" is severely biased downward, away from its true value of 1.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Empirical Finance.

    Volume (Year): 17 (2010)
    Issue (Month): 5 (December)
    Pages: 957-966

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    Handle: RePEc:eee:empfin:v:17:y:2010:i:5:p:957-966

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    Web page: http://www.elsevier.com/locate/jempfin

    Related research

    Keywords: Structural changes Forward discount rate unbiased hypothesis Exchange rates;

    References

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    Cited by:
    1. Yi-Chi Chen & Wei-Choun Yu, 2011. "Structural change in the forward discount: a Bayesian analysis of forward rate unbiasedness hypothesis," Economics Bulletin, AccessEcon, vol. 31(2), pages 1807-1826.
    2. Richard T., Baillie, 2011. "Possible solutions to the forward bias paradox," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 21(4), pages 617-622, October.
    3. Nagayasu, Jun, 2011. "The threshold nonstationary panel data approach to forward premiums," MPRA Paper 34265, University Library of Munich, Germany.
    4. Nagayasu, Jun, 2012. "Long-Run Implications of the Covered Interest Rate Parity Condition: Evidence during the Recent Crisis and Non-Crisis Periods," MPRA Paper 41566, University Library of Munich, Germany.
    5. Michael Jetter & Alex Nikolsko-Rzhevskyy, 2013. "Monetary Policy Shifts and the Forward Discount Puzzle," DOCUMENTOS DE TRABAJO CIEF 010729, UNIVERSIDAD EAFIT.

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