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The Term Structure Of Forward Exchange Premiums And The Forecastability Of Spot Exchange Rates: Correcting The Errors

  • Richard H. Clarida
  • Mark P. Taylor

We develop a framework to extract information regarding subsequent spot rate movements from the term structure of forward exchange premiums while admitting possible deviations from rationality and the presence of risk premiums. Using weekly dollar-sterling, dollar- mark, and dollar-yen data, the restrictions implied by our framework are not rejected, and spot and forward exchange rates together are well represented by a vector error correction model (VECM). Dynamic out-of-sample forecasts up to one year ahead indicate that the VECM is strikingly superior to a range of alternative forecasts, including a random walk and standard spot-forward regressions. © 1997 by the President and Fellows of Harvard College and the Massachusetts Institute of Technology

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Article provided by MIT Press in its journal The Review of Economics and Statistics.

Volume (Year): 79 (1997)
Issue (Month): 3 (August)
Pages: 353-361

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Handle: RePEc:tpr:restat:v:79:y:1997:i:3:p:353-361
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  1. Kenneth A. Froot and Jeffrey A. Frankel., 1988. "Forward Discount Bias: Is It an Exchange Risk Premium?," Economics Working Papers 8874, University of California at Berkeley.
  2. Richard H. Clarida & Mark P. Taylor, 1993. "The Term Structure of Forward Exchange Premia and the Forecastibility of Spot Exchange Rates: Correcting the Errors," NBER Working Papers 4442, National Bureau of Economic Research, Inc.
  3. Hansen, Lars Peter & Hodrick, Robert J, 1980. "Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis," Journal of Political Economy, University of Chicago Press, vol. 88(5), pages 829-53, October.
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  5. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
  6. Phillips, P C B, 1991. "Optimal Inference in Cointegrated Systems," Econometrica, Econometric Society, vol. 59(2), pages 283-306, March.
  7. Campbell, John & Shiller, Robert, 1987. "Cointegration and Tests of Present Value Models," Scholarly Articles 3122490, Harvard University Department of Economics.
  8. Osterwald-Lenum, Michael, 1992. "A Note with Quantiles of the Asymptotic Distribution of the Maximum Likelihood Cointegration Rank Test Statistics," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 54(3), pages 461-72, August.
  9. Kenneth A. Froot, 1990. "Short Rates and Expected Asset Returns," NBER Working Papers 3247, National Bureau of Economic Research, Inc.
  10. Bekaert, Geert & Hodrick, Robert J., 1993. "On biases in the measurement of foreign exchange risk premiums," Journal of International Money and Finance, Elsevier, vol. 12(2), pages 115-138, April.
  11. Taylor, Mark P, 1987. "Covered Interest Parity: A High-Frequency, High-Quality Data Study," Economica, London School of Economics and Political Science, vol. 54(216), pages 429-38, November.
  12. John F. O. Bilson, 1980. "The "Speculative Efficiency" Hypothesis," NBER Working Papers 0474, National Bureau of Economic Research, Inc.
  13. Mark P. Taylor, 1995. "The Economics of Exchange Rates," Journal of Economic Literature, American Economic Association, vol. 33(1), pages 13-47, March.
  14. Froot, Kenneth A & Scharftstein, David S & Stein, Jeremy C, 1992. " Herd on the Street: Informational Inefficiencies in a Market with Short-Term Speculation," Journal of Finance, American Finance Association, vol. 47(4), pages 1461-84, September.
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  16. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
  17. 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.
  18. 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, vol. 3(3), pages 357-368, December.
  19. Huang, Roger D., 1984. "Some alternative tests of forward exchange rates as predictors of future spot rates," Journal of International Money and Finance, Elsevier, vol. 3(2), pages 153-167, August.
  20. Longworth, David, 1981. "Testing the Efficiency of the Canadian-U.S. Exchange Market under the Assumption of no Risk Premium," Journal of Finance, American Finance Association, vol. 36(1), pages 43-49, March.
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  23. Taylor, Mark P. & Allen, Helen, 1992. "The use of technical analysis in the foreign exchange market," Journal of International Money and Finance, Elsevier, vol. 11(3), pages 304-314, June.
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