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The Term Structure of Forward Exchange Premia and the Forecastibility of Spot Exchange Rates: Correcting the Errors

  • Richard H. Clarida
  • Mark P. Taylor

We present theory and evidence that challenges the view that forward premia contain little information regarding subsequent spot rate movements. Using weekly dollar-mark and dollar sterling data, we find that spot and forward exchange rates together are well represented by a vector error correction model; that there exists exactly the number of cointegrating relationships predicted by a simple theoretical framework and that a basis for this cointegrating space is the vector of forward premia. Dynamic forecasts indicate that the information in the forward premia can be used to reduce the root mean squared forecast error for the spot rate (relative to a random walk forecast) by at least 33 percent at a 6-month horizon and by some 50 to 90 percent at a 1year horizon.

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File URL: http://www.nber.org/papers/w4442.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 4442.

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Date of creation: Aug 1993
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Publication status: published as Review of Economics and Statistics, LXXIX (August 1997).
Handle: RePEc:nbr:nberwo:4442
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  4. 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.
  5. Mark P. Taylor, 1995. "The Economics of Exchange Rates," Journal of Economic Literature, American Economic Association, vol. 33(1), pages 13-47, March.
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  9. 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.
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  12. 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.
  13. Peter C.B. Phillips, 1988. "Optimal Inference in Cointegrated Systems," Cowles Foundation Discussion Papers 866R, Cowles Foundation for Research in Economics, Yale University, revised Aug 1989.
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  15. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
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  18. Bilson, John F O, 1981. "The "Speculative Efficiency" Hypothesis," The Journal of Business, University of Chicago Press, vol. 54(3), pages 435-51, July.
  19. 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.
  20. 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.
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