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On Biases in the Measurement of Foreign Exchange Risk Premiums

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  • Geert Bekaert
  • Robert J. Hodrick

Abstract

The hypothesis that the forward rate is an unbiased predictor of the future spot rate has been consistently rejected in recent empirical studies. This paper examines several sources of measurement error and misspecification that might induce biases in such studies. Although previous inferences are shown to be robust to a failure to construct true returns and to omitted variable bias arising from conditional heteroskedasticity in spot rates, we show that the parameters were not stable over the 1975-1989 sample period. Estimation that allows for endogenous regime shifts in the parameters demonstrates that deviations from unbiasedness were more severe in the 1980's.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 3861.

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Date of creation: Oct 1991
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Publication status: published as Journal of International Money and Finance, Vol.12, no.2 (April 1993): 115-138.
Handle: RePEc:nbr:nberwo:3861

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  1. Anne Sibert, 1987. "The risk premium in the foreign exchange market," Research Working Paper, Federal Reserve Bank of Kansas City 87-07, Federal Reserve Bank of Kansas City.
  2. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, Elsevier, vol. 14(3), pages 319-338, November.
  3. Ghysels, Eric & Hall, Alastair, 1990. "Are consumption-based intertemporal capital asset pricing models structural?," Journal of Econometrics, Elsevier, Elsevier, vol. 45(1-2), pages 121-139.
  4. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, Econometric Society, vol. 50(4), pages 1029-54, July.
  5. Robert J. Hodrick & Sanjay Srivastava, 1983. "An Investigation of Risk and Return in Forward Foreign Exchange," NBER Working Papers 1180, National Bureau of Economic Research, Inc.
  6. Canova, Fabio & Marrinan, Jane, 1993. "Profits, risk, and uncertainty in foreign exchange markets," Journal of Monetary Economics, Elsevier, Elsevier, vol. 32(2), pages 259-286, November.
  7. Robert J. Hodrick, 1987. "Risk, Uncertainty and Exchange Rates," NBER Working Papers 2429, National Bureau of Economic Research, Inc.
  8. Baillie, Richard T. & Bollerslev, Tim, 1990. "A multivariate generalized ARCH approach to modeling risk premia in forward foreign exchange rate markets," Journal of International Money and Finance, Elsevier, Elsevier, vol. 9(3), pages 309-324, September.
  9. Korajczyk, Robert A. & Viallet, Claude J., 1992. "Equity risk premia and the pricing of foreign exchange risk," Journal of International Economics, Elsevier, Elsevier, vol. 33(3-4), pages 199-219, November.
  10. Engel, Charles, 1992. "On the foreign exchange risk premium in a general equilibrium model," Journal of International Economics, Elsevier, Elsevier, vol. 32(3-4), pages 305-319, May.
  11. Domowitz, Ian & Hakkio, Craig S., 1985. "Conditional variance and the risk premium in the foreign exchange market," Journal of International Economics, Elsevier, Elsevier, vol. 19(1-2), pages 47-66, August.
  12. Bossaerts, Peter & Hillion, Pierre, 1991. "Market Microstructure Effects of Government Intervention in the Foreign Exchange Market," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 4(3), pages 513-41.
  13. John F. O. Bilson, 1980. "The "Speculative Efficiency" Hypothesis," NBER Working Papers 0474, National Bureau of Economic Research, Inc.
  14. Hamilton, James D., 1990. "Analysis of time series subject to changes in regime," Journal of Econometrics, Elsevier, Elsevier, vol. 45(1-2), pages 39-70.
  15. Cornell, Bradford, 1989. "The impact of data errors on measurement of the foreign exchange risk premium," Journal of International Money and Finance, Elsevier, Elsevier, vol. 8(1), pages 147-157, March.
  16. Paul A. Ruud., 1988. "Extensions of Estimation Methods Using the EM Algorithm.," Economics Working Papers, University of California at Berkeley 8899, University of California at Berkeley.
  17. Gregory, Allan W. & McCurdy, Thomas H., 1984. "Testing the unbiasedness hypothesis in the forward foreign exchange market: A specification analysis," Journal of International Money and Finance, Elsevier, Elsevier, vol. 3(3), pages 357-368, December.
  18. White, Halbert, 1980. "A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroskedasticity," Econometrica, Econometric Society, Econometric Society, vol. 48(4), pages 817-38, May.
  19. Frenkel, Jacob A. & Razin, Assaf, 1980. "Stochastic prices and tests of efficiency of foreign exchange markets," Economics Letters, Elsevier, Elsevier, vol. 6(2), pages 165-170.
  20. Lars Peter Hansen & Robert J. Hodrick, 1983. "Risk Averse Speculation in the Forward Foreign Exchange Market: An Econometric Analysis of Linear Models," NBER Chapters, in: Exchange Rates and International Macroeconomics, pages 113-152 National Bureau of Economic Research, Inc.
  21. Froot, Kenneth A & Thaler, Richard H, 1990. "Foreign Exchange," Journal of Economic Perspectives, American Economic Association, American Economic Association, vol. 4(3), pages 179-92, Summer.
  22. Lucas, Robert Jr., 1982. "Interest rates and currency prices in a two-country world," Journal of Monetary Economics, Elsevier, Elsevier, vol. 10(3), pages 335-359.
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