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The Term Structure of Forward Exchange Premia and the Forecastibility of Spot Exchange Rates: Correcting the Errors

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  • Richard H. Clarida
  • Mark P. Taylor

Abstract

We present theory and evidence that challenges the view that forward premia contain little information regarding subsequent spot rate movements. Using weekly dollar-mark and dollar sterling data, we find that spot and forward exchange rates together are well represented by a vector error correction model; that there exists exactly the number of cointegrating relationships predicted by a simple theoretical framework and that a basis for this cointegrating space is the vector of forward premia. Dynamic forecasts indicate that the information in the forward premia can be used to reduce the root mean squared forecast error for the spot rate (relative to a random walk forecast) by at least 33 percent at a 6-month horizon and by some 50 to 90 percent at a 1year horizon.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 4442.

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Date of creation: Aug 1993
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Publication status: published as Review of Economics and Statistics, LXXIX (August 1997).
Handle: RePEc:nbr:nberwo:4442

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  1. David M. Cutler & James M. Poterba & Lawrence H. Summers, 1990. "Speculative Dynamics and the Role of Feedback Traders," NBER Working Papers 3243, National Bureau of Economic Research, Inc.
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Cited by:
  1. Alex Maynard & Peter C. B. Phillips, 2001. "Rethinking an old empirical puzzle: econometric evidence on the forward discount anomaly," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 16(6), pages 671-708.
  2. Gruen, D.W.R. & Gizycki, M.C., 1993. "Explaining Forward Discount Bias: Is It Anchoring?," Papers 164, Princeton, Woodrow Wilson School - Public and International Affairs.
  3. repec:dgr:uvatin:1997041 is not listed on IDEAS
  4. Sergio L. Schmukler & Luis Serven, 2002. "Pricing Currency Risk: Facts and Puzzles from Currency Boards," NBER Working Papers 9047, National Bureau of Economic Research, Inc.
  5. Schmukler, Sergio L. & Serven, Luis, 2002. "Pricing currency risk under currency boards," Journal of Development Economics, Elsevier, vol. 69(2), pages 367-391, December.
  6. repec:dgr:uvatin:2097041 is not listed on IDEAS

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