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Cointegrating behaviour between spot and forward exchange rates

  • David McMillan
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    This paper re-considers cointegrating behaviour between forward and spot exchange rates and the implications for the forward rate unbiasedness hypothesis. Extant empirical evidence examining forward and future spot rates is mixed, offering results both for and against cointegration; the forward rate as an unbiased predictor of the spot rate; and the existence of a time-varying risk premium. However, recent research has suggested that such analysis may be subject to bias and that models of cointegration between forward and current spot rates should instead serve as a starting point for analysis of exchange rate behaviour. Johansen cointegration analysis supports this contention showing that erroneous inferences can be made by merely using future spot rate data. Subsequently both single equation and panel estimation methods support cointegration between forward and current spot rates, but that the forward rate is a biased predictor. Further, single equation tests are conducted over a rolling window of five years through our sample. These results largely confirm those for the full sample.

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    File URL: http://www.tandfonline.com/doi/abs/10.1080/09603100500359476
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    Article provided by Taylor & Francis Journals in its journal Applied Financial Economics.

    Volume (Year): 15 (2005)
    Issue (Month): 16 ()
    Pages: 1135-1144

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    Handle: RePEc:taf:apfiec:v:15:y:2005:i:16:p:1135-1144
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    1. Peter Pedroni, 1999. "Critical Values for Cointegration Tests in Heterogeneous Panels with Multiple Regressors," Department of Economics Working Papers 2000-02, Department of Economics, Williams College.
    2. John Barkoulas & Christopher F. Baum, 1996. "A Re-examination of the Fragility of Evidence from Cointegration- Based Tests of Foreign Exchange Market Efficiency," Boston College Working Papers in Economics 311., Boston College Department of Economics.
    3. Levin, Andrew & Lin, Chien-Fu & James Chu, Chia-Shang, 2002. "Unit root tests in panel data: asymptotic and finite-sample properties," Journal of Econometrics, Elsevier, vol. 108(1), pages 1-24, May.
    4. Diebold, Francis X & Gardeazabal, Javier & Yilmaz, Kamil, 1994. " On Cointegration and Exchange Rate Dynamics," Journal of Finance, American Finance Association, vol. 49(2), pages 727-35, June.
    5. Johansen, Soren, 1995. "Likelihood-Based Inference in Cointegrated Vector Autoregressive Models," OUP Catalogue, Oxford University Press, number 9780198774501, March.
    6. Luintel, K. B. & Paudyal, K., 1998. "Common stochastic trends between forward and spot exchange rates," Journal of International Money and Finance, Elsevier, vol. 17(2), pages 279-297, April.
    7. Baillie, Richard T & Bollerslev, Tim, 1989. " Common Stochastic Trends in a System of Exchange Rates," Journal of Finance, American Finance Association, vol. 44(1), pages 167-81, March.
    8. Baillie, Richard T & Bollerslev, Tim, 1994. " Cointegration, Fractional Cointegration, and Exchange Rate Dynamics," Journal of Finance, American Finance Association, vol. 49(2), pages 737-45, June.
    9. Pasaran, M.H. & Im, K.S. & Shin, Y., 1995. "Testing for Unit Roots in Heterogeneous Panels," Cambridge Working Papers in Economics 9526, Faculty of Economics, University of Cambridge.
    10. Peter Pedroni, 2001. "Purchasing Power Parity Tests In Cointegrated Panels," The Review of Economics and Statistics, MIT Press, vol. 83(4), pages 727-731, November.
    11. Eric Zivot, 1998. "Cointegration and Forward and Spot Exchange Rate Regressions," Econometrics 9812001, EconWPA.
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