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Forward Exchange Rate Puzzle: Joining the Missing Pieces in the Rand-US Dollar Exchange Market

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  • Lumengo Bonga-Bonga

Abstract

The Unbiased Forward Rate Hypothesis (UFRH) stipulates that the forward rates should be a perfect predictor for the future spot rates. A number of studies have tested the UFRH and foreign market efficiency and concluded that the hypothesis does not hold. This phenomenon is known as the UFRH puzzle. A number of studies that reject the UFRH have made use of ordinary least square (OLS) methods and support a linear adjustment between spot and forward exchange rates. This paper establishes that the use of a linear model in testing the UFRH can lead to a misspecification problem if indeed there is a nonlinear adjustment between the forward and spot exchange rates. In order to overcome the problem of model misspecification, this paper applies the nonlinear method of the class of the Smooth Transition Regression (STR) model in assessing the relationship between the Rand-US Dollar future spot and forward exchange rates. With the aid of a series of diagnostic tests, the paper shows that there is indeed a nonlinear adjustment process between the Rand-US Dollar spot and forward exchange rates and that there exists a regime in the STR model where the UFRH eventually holds. Furthermore, the out-of-sample forecast results show that the STR forecasting method outperforms the OLS and random walk methods in forecasting the future spot exchange rate.

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Bibliographic Info

Paper provided by Economic Research Southern Africa in its series Working Papers with number 122.

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Date of creation: 2009
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Handle: RePEc:rza:wpaper:122

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Cited by:
  1. Goodness C. Aye & Mehmet Balcilar & Adel Bosch & Rangan Gupta & Francois Stofberg, 2013. "The out-of-sample forecasting performance of non-linear models of real exchange rate behaviour: The case of the South African Rand," Working Papers 201304, University of Pretoria, Department of Economics.
  2. Dhekra Azouzi & Rohit Vishal Kumar & Chaker Aloui, 2011. "Forward Rate Unbiasedness Hypothesis in the Tunisian Exchange Rate Market," International Journal of Academic Research in Business and Social Sciences, Human Resource Management Academic Research Society, International Journal of Academic Research in Business and Social Sciences, vol. 1(2), pages 17-44, July.
  3. Riane de Bruyn & Rangan Gupta & Renee van Eyden, 2013. "Forecasting The Rand-Dollar And Rand-Pound Exchange Rates Using Dynamic Model Averaging," Working Papers 201307, University of Pretoria, Department of Economics.
  4. Rohit Vishal Kumar & Dhekra Azouzi, 2011. "Tunisian and Indian Forex Markets: A Comparision on Forward Rate Unbiased Hypothesis," Romanian Economic Journal, Department of International Business and Economics from the Academy of Economic Studies Bucharest, vol. 14(40), pages 81-98, June.

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