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Abstract
This paper reexamines a familiar relationship in literature: that the forward rate is an unbiased predictor of the future spot rate at one, three and six month intervals. We find that the forward rates have little power in predicting the future spot rate as some crucial information that is available with economic agents is only known at later dates and news that is only partially known at the time of the forecast becomes known only at the date of maturity. Also, a longer horizon forward rate, such as the 1-year forward exchange contract has more information about the spot exchange rate than the shorter horizon of 30 days or even 3 months.
Keywords: Forward Exchange Rate, Forward Premia, Spot Rate, Unbiased Forward Rate Hypothesis, Risk Premium.
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1. Introduction
A significant amount of empirical work has been devoted to analyzing; 'Is the forward exchange rate an unbiased predictor of the future spot exchange rates? Empirical tests have been performed across countries for many years and much of the recent research on this topic has concluded that it is not (Barnhart, Mcnown and Wallace, 1999). The general consensus is that forward rates are not very good predictors of future spot rates. For example, the studies of Hansen and Hodrick (1980), Fama (1984), and Wolff (1987) find that the existence of time-varying risk premia obstructs the relationship between the future spot rate and the current forward rate. However, studies by Frankel (1980), Hansen and Hodrick (1980), Froot and Frankel (1989) and Frankel (1993) have failed to identify a significant risk premia in many different data sets. They concluded that the failure of the hypotheses is indicative of the failure of rational expectations in the form of excessive speculations.
Fama (1984) attributed the failure of the hypothesis to an extremely variable rational expectations risk premium. In his 1984 article, Fama showed that the bias in the forward premium regression is a function of the covariance between the expected change in the spot rate and, in his specification, a risk premium.
Built on previous empirical research and evidence, this paper is an attempt to examine the relationship between forward rates and future spot rates for five currencies and three maturity periods using...