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Testing the unbiased forward exchange rate hypothesis using a Markov switching model and instrumental variables

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  • Martin Sola
  • Zacharias Psaradakis

    (School of Economics, Mathematics & Statistics, Birkbeck College, London, UK)

  • Fabio Spagnolo

    (CARISMA and Department of Economics and Finance, Brunel University, Uxbridge, UK)

Abstract

This paper develops a model for the forward and spot exchange rate which allows for the presence of a Markov switching risk premium in the forward market and considers the issue of testing the unbiased forward exchange rate (UFER) hypothesis. Using US|UK data, it is shown that the UFER hypothesis cannot be rejected, provided that instrumental variables are used to account for within-regime correlation between explanatory variables and disturbances in the Markov switching model on which the test is based. Copyright © 2005 John Wiley & Sons, Ltd.

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Bibliographic Info

Article provided by John Wiley & Sons, Ltd. in its journal Journal of Applied Econometrics.

Volume (Year): 20 (2005)
Issue (Month): 3 ()
Pages: 423-437

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Handle: RePEc:jae:japmet:v:20:y:2005:i:3:p:423-437

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  1. Hansen, Bruce E, 1992. "The Likelihood Ratio Test under Nonstandard Conditions: Testing the Markov Switching Model of GNP," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 7(S), pages S61-82, Suppl. De.
  2. Hall, Stephen G & Psaradakis, Zacharias & Sola, Martin, 1997. "Cointegration and Changes in Regime: The Japanese Consumption Function," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 12(2), pages 151-68, March-Apr.
  3. 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.
  4. Mankiw, N Gregory & Miron, Jeffrey A, 1986. "The Changing Behavior of the Term Structure of Interest Rates," The Quarterly Journal of Economics, MIT Press, vol. 101(2), pages 211-28, May.
  5. Hansen, Bruce E, 1996. "Erratum: The Likelihood Ratio Test under Nonstandard Conditions: Testing the Markov Switching Model of GNP," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 11(2), pages 195-98, March-Apr.
  6. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, December.
  7. Psaradakis, Zacharias & Sola, Martin, 1998. "Finite-sample properties of the maximum likelihood estimator in autoregressive models with Markov switching," Journal of Econometrics, Elsevier, vol. 86(2), pages 369-386, June.
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Cited by:
  1. Zheng, Tingguo & Zuo, Haomiao, 2013. "Reexamining the time-varying volatility spillover effects: A Markov switching causality approach," The North American Journal of Economics and Finance, Elsevier, vol. 26(C), pages 643-662.
  2. repec:wyi:journl:002202 is not listed on IDEAS
  3. repec:hal:journl:halshs-00658540 is not listed on IDEAS
  4. Chevallier, Julien, 2011. "Evaluating the carbon-macroeconomy relationship: Evidence from threshold vector error-correction and Markov-switching VAR models," Economics Papers from University Paris Dauphine 123456789/6970, Paris Dauphine University.
  5. Zhiguang Wang & Prasad Bidarkota, 2012. "Risk premia in forward foreign exchange rates: a comparison of signal extraction and regression methods," Empirical Economics, Springer, vol. 42(1), pages 21-51, February.
  6. Balvers, Ronald J. & Klein, Alina F., 2014. "Currency risk premia and uncovered interest parity in the International CAPM," Journal of International Money and Finance, Elsevier, vol. 41(C), pages 214-230.
  7. Brian Lucey & Grace Loring, 2012. "Forward Exchange Rate Biasedness across Developed and Developing Country Currencies - Do Observed Patterns Persist Out of Sample?Abstract:," The Institute for International Integration Studies Discussion Paper Series iiisdp404, IIIS.
  8. repec:hal:cesptp:halshs-00658540 is not listed on IDEAS
  9. Jinho Bae & Chang-Jin Kim & Dong Kim, 2012. "The evolution of the monetary policy regimes in the U.S," Empirical Economics, Springer, vol. 43(2), pages 617-649, October.

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