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

35 Pages Posted: 26 Apr 2001 Last revised: 22 Aug 2022

See all articles by Richard Clarida

Richard Clarida

Columbia University - Graduate School of Arts and Sciences - Department of Eco; National Bureau of Economic Research (NBER)

Mark P. Taylor

Washington University in St. Louis - John M. Olin Business School; Centre for Economic Policy Research (CEPR); Brookings Institution

Date Written: August 1993

Abstract

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.

Suggested Citation

Clarida, Richard H. and Taylor, Mark P., The Term Structure of Forward Exchange Premia and the Forecastibility of Spot Exchange Rates: Correcting the Errors (August 1993). NBER Working Paper No. w4442, Available at SSRN: https://ssrn.com/abstract=227304

Richard H. Clarida (Contact Author)

Columbia University - Graduate School of Arts and Sciences - Department of Eco ( email )

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Mark P. Taylor

Washington University in St. Louis - John M. Olin Business School ( email )

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