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What Is Wrong with Market-Based Forecasting of Exchange Rates?

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  • Imad A. Moosa

    (Department of Economics and Finance, La Trobe University, Australia)

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    Abstract

    Market-based forecasting of exchange rates is flawed because it is based on two hypotheses that are not supported by empirical evidence: the simple random walk hypothesis and the unbiased efficiency hypothesis. By using historical data on six currency combinations it is shown that these two hypotheses are rejected because of the presence of a significant time-varying drift factor and what is typically perceived as a risk premium. It is also shown that the model representing the unbiased efficiency hypothesis is misspecified because the relationship between the spot and forward exchange rates is contemporaneous rather than lagged. The results cast doubt on the usefulness of the spot and lagged forward rates as benchmarks for measuring the forecasting power of time series and structural models. It is also demonstrated that market-based forecasting may lead to faulty financial decisions.

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    Bibliographic Info

    Article provided by College of Business, and College of Finance, Feng Chia University, Taichung, Taiwan in its journal International Journal of Business and Economics.

    Volume (Year): 3 (2004)
    Issue (Month): 2 (August)
    Pages: 107-121

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    Handle: RePEc:ijb:journl:v:3:y:2004:i:2:p:107-121

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    Related research

    Keywords: market-based forecasting; random walk; unbiased efficiency; covered interest parity;

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    1. Albert Wang, F., 1998. "Strategic trading, asymmetric information and heterogeneous prior beliefs," Journal of Financial Markets, Elsevier, vol. 1(3-4), pages 321-352, September.
    2. Zhu, Zhen, 2002. "Time-varying forward bias and the expected excess return," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 12(2), pages 119-137, April.
    3. Takatoshi Ito, 1988. "Foreign Exchange Rate Expectations: Micro Survey Data," NBER Working Papers 2679, National Bureau of Economic Research, Inc.
    4. Chavas, Jean-Paul, 1999. "On The Economic Rationality Of Market Participants: The Case Of Expectations In The U.S. Pork Market," Journal of Agricultural and Resource Economics, Western Agricultural Economics Association, vol. 24(01), July.
    5. Harrison, J Michael & Kreps, David M, 1978. "Speculative Investor Behavior in a Stock Market with Heterogeneous Expectations," The Quarterly Journal of Economics, MIT Press, vol. 92(2), pages 323-36, May.
    6. Wolff, Christian C P, 1987. "Time-Varying Parameters and the Out-of-Sample Forecasting Performance of Structural Exchange Rate Models," Journal of Business & Economic Statistics, American Statistical Association, vol. 5(1), pages 87-97, January.
    7. Wang, Peijie & Jones, Trefor, 2002. "Testing for efficiency and rationality in foreign exchange markets--a review of the literature and research on foreign exchange market efficiency and rationality with comments," Journal of International Money and Finance, Elsevier, vol. 21(2), pages 223-239, April.
    8. Dufey, Gunter & Kazemi, Hossein B., 1991. "Demand and supply of forward exchange contracts under incomplete information," Journal of Economics and Business, Elsevier, vol. 43(4), pages 339-352, November.
    9. Charles Engel, 1995. "The Forward Discount Anomaly and the Risk Premium: A Survey of Recent Evidence," NBER Working Papers 5312, National Bureau of Economic Research, Inc.
    10. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
    11. Imad Moosa, 1999. "Testing the currency-substitution model under the German hyperinflation," Journal of Economics, Springer, vol. 70(1), pages 61-78, February.
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