Resolving the unbiasedness puzzle in the foreign exchange market
An unresolved puzzle in the empirical foreign exchange literature is that tests of forward rate unbiasedness using the forward rate and forward premium equations yield markedly different conclusions about the unbiasedness of the forward exchange rate. This puzzle is resolved by showing that because of the persistence in exchange rates, estimates of the slope coefficient from the forward premium equation are extremely sensitive to small violations of the null hypothesis of the type and magnitude that are likely to exist in the real world. Moreover, contrary to suggestions in the literature and common practice, the forward premium equation does not necessarily provide a better test of unbiasedness than the forward rate equation.
|Date of creation:||2009|
|Date of revision:|
|Contact details of provider:|| Postal: |
Web page: http://www.stlouisfed.org/
More information through EDIRC
|Order Information:|| Email: |
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Barnhart, Scott W. & McNown, Robert & Wallace, Myles S., 1999. "Non-Informative Tests of the Unbiased Forward Exchange Rate," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 34(02), pages 265-291, June.
- Geert Bekaert & Robert J. Hodrick & David A. Marshall, 1996.
"On Biases in Tests of the Expecations Hypothesis of the Term Structure Of Interest Rates,"
NBER Technical Working Papers
0191, National Bureau of Economic Research, Inc.
- Bekaert, Geert & Hodrick, Robert J. & Marshall, David A., 1997. "On biases in tests of the expectations hypothesis of the term structure of interest rates," Journal of Financial Economics, Elsevier, vol. 44(3), pages 309-348, June.
- Geert Bekaert & Robert J. Hodrick & David Marshall, 1996. "On biases in tests of the expectations hypothesis of the term structure of interest rates," Working Paper Series, Issues in Financial Regulation WP-96-3, Federal Reserve Bank of Chicago.
- Bennett T. McCallum, 1992.
"A Reconsideration of the Uncovered Interest Parity Relationship,"
NBER Working Papers
4113, National Bureau of Economic Research, Inc.
- McCallum, Bennett T., 1994. "A reconsideration of the uncovered interest parity relationship," Journal of Monetary Economics, Elsevier, vol. 33(1), pages 105-132, February.
- Goodhart, Charles A E & McMahon, Patrick C & Ngama, Yerima L, 1997. "Why Does the Spot-Forward Discount Fail to Predict Changes in Future Spot Rates," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 2(2), pages 121-29, April.
- Leon, Hyginus & Sarno, Lucio & Valente, Giorgio, 2006.
"Nonlinearity in Deviations from Uncovered Interest Parity: An Explanation of the Forward Bias Puzzle,"
CEPR Discussion Papers
5527, C.E.P.R. Discussion Papers.
- Lucio Sarno & Giorgio Valente & Hyginus Leon, 2006. "Nonlinearity in Deviations from Uncovered Interest Parity: An Explanation of the Forward Bias Puzzle," Review of Finance, European Finance Association, vol. 10(3), pages 443-482, September.
- Giorgio Valente & H. L. Leon & Lucio Sarno, 2006. "Nonlinearity in Deviations From Uncovered Interest Parity: An Explanation of the Forward Bias Puzzle," IMF Working Papers 06/136, International Monetary Fund.
- Richard T. Baillie & Rehim Kilic, 2005.
"Do Asymmetric and Nonlinear Adjustments Explain the Forward Premium Anomaly?,"
543, Queen Mary University of London, School of Economics and Finance.
- Baillie, Richard T. & Kilic, Rehim, 2006. "Do asymmetric and nonlinear adjustments explain the forward premium anomaly?," Journal of International Money and Finance, Elsevier, vol. 25(1), pages 22-47, February.
- 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.
- Meese, Richard A & Singleton, Kenneth J, 1982. " On Unit Roots and the Empirical Modeling of Exchange Rates," Journal of Finance, American Finance Association, vol. 37(4), pages 1029-35, September.
- McCulloch, J Huston, 1975. "Operational Aspects of the Siegel Paradox: Comment," The Quarterly Journal of Economics, MIT Press, vol. 89(1), pages 170-72, February.
- Frenkel, Jacob A, 1981. "Flexible Exchange Rates, Prices, and the Role of "News": Lessons from the 1970s," Journal of Political Economy, University of Chicago Press, vol. 89(4), pages 665-705, August.
- Frenkel, Jacob A, 1976. " A Monetary Approach to the Exchange Rate: Doctrinal Aspects and Empirical Evidence," Scandinavian Journal of Economics, Wiley Blackwell, vol. 78(2), pages 200-224.
- Alex Maynard & Peter C. B. Phillips, 2001. "Rethinking an old empirical puzzle: econometric evidence on the forward discount anomaly," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 16(6), pages 671-708.
When requesting a correction, please mention this item's handle: RePEc:fip:fedlwp:2009-002. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Anna Xiao)
If references are entirely missing, you can add them using this form.