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Time-Variation and Structural Change in the Forward Discount: Implications for the Forward Rate Unbiasedness Hypothesis

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  • George Sakoulis

    (University of Washington)

  • Eric Zivot

    (University of Washington)

Abstract

It is a well accepted empirical result that forward exchange rate unbiasedness is rejected in tests of the `differences regression' of the change in the logarithm of the spot exchange rate on the forward discount. The result is referred to in the International Finance literature as the forward discount puzzle. Competing explanations of the negative bias of the forward discount coefficient include the possibilities of a time-varying risk premium or the existence of `peso problems.' We offer an alternative explanation for this anomaly. One of the stylized facts about the forward discount is that it is highly persistent. We model the forward discount as an AR(1) process and argue that its persistence is exaggerated due to the presence of structural breaks. We document the temporal variation in persistence, using a time-varying parameter specification for the AR(1) model, with Markov-switching disturbances. We also show, using a stochastic multiple break model, suggested recently by Bai and Perron (1998), that for the G-7 countries, with the exception of Japan, the forward discount persistence is substantially less, if one allows for multiple structural breaks in the mean of the process. These breaks could be identified as monetary shocks to the central bank's reaction function, as discussed in Eichenbaum and Evans (1995). Using Monte Carlo simulations we show that in the absence of a foreign exchange risk premium, if we do not account for structural breaks which are present in the forward discount process, the forward discount coefficient in the `differences regression' is severely biased downward, away from its true value of 1.

Suggested Citation

  • George Sakoulis & Eric Zivot, 2000. "Time-Variation and Structural Change in the Forward Discount: Implications for the Forward Rate Unbiasedness Hypothesis," Econometric Society World Congress 2000 Contributed Papers 1583, Econometric Society.
  • Handle: RePEc:ecm:wc2000:1583
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    Cited by:

    1. Kyongwook Choi & Eric Zivot, 2003. "Long Memory and Structural Changes in the Forward Discount: An Empirical Investigation," EERI Research Paper Series EERI_RP_2003_02, Economics and Econometrics Research Institute (EERI), Brussels.
    2. Hillebrand, Eric, 2005. "Neglecting parameter changes in GARCH models," Journal of Econometrics, Elsevier, vol. 129(1-2), pages 121-138.
    3. Alex Maynard, 2006. "The forward premium anomaly: statistical artefact or economic puzzle? New evidence from robust tests," Canadian Journal of Economics, Canadian Economics Association, vol. 39(4), pages 1244-1281, November.
    4. Kyongwook Choi & Eric Zivot, 2003. "Long Memory and Structural Changes in the Forward Discount: An Empirical Investigation," Econometrics 0307001, EconWPA, revised 23 Jul 2003.

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