Munich Personal RePEc Archive

The risk premium, exchange rate expectations, and the forward exchange rate: Estimates for the Yen-Dollar rate

Landon, Stuart and Smith, Constance (1999): The risk premium, exchange rate expectations, and the forward exchange rate: Estimates for the Yen-Dollar rate.

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Abstract

The forward rate is often used as the market's prediction of the future spot exchange rate even though the hypothesis that the forward rate is an unbiased predictor of the future spot rate has been rejected in a large number of empirical studies using data for different countries and time periods. The rejection of this hypothesis could occur because market behaviour is inconsistent with rational expectations or because of the existence of a risk premium. Existing studies test for one or the other, but not both, of these factors. In this paper, equations describing the forward premium and the change in the exchange rate are estimated jointly, and tests of both the rational expectations and no risk premium hypotheses are conducted. The empirical estimates, obtained using quarterly data for the yen-dollar exchange rate, reject the rational expectations hypothesis and suggest that there exists a time-varying risk premium.

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