An analysis of the unbiased forward rate hypothesis in developed and emerging economies

Phungo, Muka and Bonga-Bonga, Lumengo (2019): An analysis of the unbiased forward rate hypothesis in developed and emerging economies.

Abstract

This study assesses whether the unbiased forward rate hypothesis (UFRH) holds in its strong or weak form in selected developed and emerging economies. Moreover, the paper assesses whether this hypothesis, or the relationship between the forward and spot exchange rates, is better specified by a linear or nonlinear model. The paper makes use of the smooth transition error correction model (STECM) to account for long-run relationship and asymmetric adjustment between the two exchange rates. The results of the empirical analysis show the possibility of nonlinear cointegration between the spot and forward exchange rates in a number of developed and emerging economies. In addition, the results reveal that the magnitude of the speed of adjustment to cancel arbitrage opportunities is higher in emerging than in developed markets. This occurs because the size of arbitrage profit is higher in emerging markets compared to developed markets

• Item Type: MPRA Paper
• Language: English
• Keywords: forward market, spot market, exchange rate, unbiased forward rate hypothesis, smooth transition error correction model
• Subjects: C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C50 - General; G - Financial Economics > G1 - General Financial Markets > G14 - Information and Market Efficiency ; Event Studies ; Insider Trading; G - Financial Economics > G1 - General Financial Markets > G15 - International Financial Markets

References

Aggarwal, R., Lucey, B.M. and Mohanty, S.K., 2009. The forward exchange rate bias puzzle is persistent: Evidence from stochastic and nonparametric cointegration tests. Financial Review, 44(4), pp.625-645.

Amri, S., 2008. Analysing the forward premium anomaly using a Logistic Smooth Transition Regression model. Economics Bulletin, 6(26), pp.1-18.

Asteriou, D. and Hall, S.G., 2007. A Modern Approach Using Eviews and Microfit (Revised Edition).

Azouzi, D., Kumar, R.V. and Aloui, C., 2011. Forward rate unbiasedness hypothesis in the Tunisian exchange rate market. International Journal of Academic Research in Business and Social Sciences, 1(2), p.17.

Barnhart, S.W. and Szakmary, A.C., 1991. Testing the unbiased forward rate hypothesis: evidence on unit roots, co-integration, and stochastic coefficients. Journal of Financial and Quantitative Analysis, 26(2), pp.245-267.

Bonga-Bonga, L., 2008. Modelling the Rand-Dollar future spot rates: The Kalman filter approach. African Finance Journal, 10(2), pp.60-76.

Bonga-Bonga, L., 2009. Forward exchange rate puzzle: Joining the missing pieces in the rand-US dollar exchange market. Studies in Economics and Econometrics, 33(2), pp.33-48.

Chiang, T.C., 1988. The forward rate as a predictor of the future spot rate--A stochastic coefficient approach. Journal of Money, Credit and Banking, 20(2), pp.212-232.

Delcoure, N., Barkoulas, J., Baum, C.F. and Chakraborty, A., 2003. The forward rate unbiasedness hypothesis re-examined: evidence from a new test. Global Finance Journal, 14(1), pp.83-93.

Engel, C., 1996. The forward discount anomaly and the risk premium: A survey of recent evidence. Journal of empirical finance, 3(2), pp.123-192.

Frankel, J.A. and Froot, K., 1986. Interpreting tests of forward discount bias using survey data on exchange rate expectations. National Bureau of Economic Research.

Frankel, J. and Poonawala, J., 2010. The forward market in emerging currencies: Less biased than in major currencies. Journal of International Money and Finance, 29(3), pp.585-598.

Geweke, J. and Feige, E., 1979. Some joint tests of the efficiency of markets for forward foreign exchange. The Review of Economics and Statistics, pp.334-341.

Giannellis, N. and Papadopoulos, A.P., 2009. Testing for efficiency in selected developing foreign exchange markets: An equilibrium-based approach. Economic Modelling, 26(1), pp.155-166.

Gregory, A.W. and McCurdy, T.H., 1984. Testing the unbiasedness hypothesis in the forward foreign exchange market: A specification analysis. Journal of International Money and Finance, 3(3), pp.357-368.

Ho, T.W. and Mo, W.S., 2016. Testing the Persistence of the Forward Premium: Structural Changes or Misspecification?. Open Economies Review, 27(1), pp.119-138.

Hodrick, R.J. and Srivastava, S., 1984. An investigation of risk and return in forward foreign exchange. Journal of International Money and Finance, 3(1), pp.5-29.

Ichiue, H. and Koyama, K., 2011. Regime switches in exchange rate volatility and uncovered interest parity. Journal of International Money and Finance, 30(7), pp.1436-1450.

Kılıç, R., 2011. Testing for co‐integration and nonlinear adjustment in a smooth transition error correction model. Journal of Time Series Analysis, 32(6), pp.647-660.

Kratzig, M., 2005. STR analysis in JMulti. Jmulti Documentation.

Li, D., Ghoshray, A. and Morley, B., 2013. An empirical study of nonlinear adjustment in the UIP model using a smooth transition regression model. International Review of Financial Analysis, 30, pp.109-120.

Lütkepohl, H. and Krätzig, 2004. Applied time series econometrics. Cambridge university press.

Mazur, M.E. and Ramirez, M.D., 2013. The Forward Exchange Rate Unbiasedness Hypothesis: A Single Break Unit Root and Cointegration Analysis.

Phillips, P.C. and McFarland, J.W., 1997. Forward exchange market unbiasedness: the case of the Australian dollar since 1984. Journal of International Money and Finance, 16(6), pp.885-907.

Sakoulis, G. and Zivot, E., 2001. Time-variation and structural change in the forward discount: Implications for the forward rate unbiasedness hypothesis. University of Washington, Department of Economics, pp.1-44.

Sarno, L., Valente, G. and Leon, H., 2006. Nonlinearity in deviations from uncovered interest parity: an explanation of the forward bias puzzle. Review of Finance, 10(3), pp.443-482.

Snaith, S., Coakley, J. and Kellard, N., 2013. Does the forward premium puzzle disappear over the horizon?. Journal of Banking & Finance, 37(9), pp.3681-3693.

Spagnolo, F., Psaradakis, Z. and Sola, M., 2005. Testing the unbiased forward exchange rate hypothesis using a Markov switching model and instrumental variables. Journal of Applied Econometrics, 20(3), pp.423-437.

Teräsvirta, T., 1994. Specification, estimation, and evaluation of smooth transition autoregressive models. Journal of the american Statistical association, 89(425), pp.208-218.

Zacharatos, N. and Sutcliffe, C., 2002. Is the forward rate for the Greek drachma unbiased? A VECM analysis with both overlapping and non-overlapping data. Journal of Financial Management & Analysis, 15(1), p.27.