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The forward exchange rate bias: a new explanation

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  • Ross Levine

Abstract

Although the literature has devoted prodigious resources to investigating the risk premium explanation of the systematic time-varying discrepancies between forward and corresponding future spot exchange rates, empirical verification of the risk premium hypothesis has proven elusive. This paper tests an alternative explanation of the forward bias: the anticipated real exchange rate hypothesis. This hypothesis states that except for a constant risk premium, the predictable, time varying wedge between forward and expected future spot exchange rates is fully explained by the anticipated rate of change in the real exchange rate. The data do not reject this hypothesis. This suggests that the literature's almost singular concern with the risk premium explanation of the forward bias should be amended to include the effects of anticipated real exchange rate movements.

Suggested Citation

  • Ross Levine, 1988. "The forward exchange rate bias: a new explanation," International Finance Discussion Papers 338, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgif:338
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    1. Cumby, Robert E. & Huizinga, John, 1991. "The predictability of real exchange rate changes in the short and long run," Japan and the World Economy, Elsevier, vol. 3(1), pages 17-38, April.

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