Testing the Unbiased Forward Exchange Rate Hypothesis Using a Markov Switching Model and Instrumental Variables

Journal of Applied Econometrics, Forthcoming

Posted: 6 Dec 2004

See all articles by Fabio Spagnolo

Fabio Spagnolo

Brunel University London - Economics and Finance

Zacharias Psaradakis

University of London - Economics, Mathematics and Statistics

Martín Sola

Universidad Torcuato Di Tella; University of London - Economics, Mathematics and Statistics

Abstract

This paper develops a model for the forward and spot exchange rate which allows for the presence of a Markov switching risk premium in the forward market and considers the issue of testing the unbiased forward exchange rate (UFER) hypothesis. Using US/UK data, it is shown that the UFER hypothesis cannot be rejected, provided that instrumental variables are used to account for within-regime correlation between explanatory variables and disturbances in the Markov switching model on which the test is based.

Keywords: Instrumental variables, forward exchange rate, Markov chain, maximum likelihood, Regime switching

JEL Classification: C13, C22, F31

Suggested Citation

Spagnolo, Fabio and Psaradakis, Zacharias and Sola, Martín, Testing the Unbiased Forward Exchange Rate Hypothesis Using a Markov Switching Model and Instrumental Variables. Journal of Applied Econometrics, Forthcoming. Available at SSRN: https://ssrn.com/abstract=626804

Fabio Spagnolo (Contact Author)

Brunel University London - Economics and Finance ( email )

Uxbridge UB8 3PH
United Kingdom
+44 1895 816383 (Phone)
+44 1895 203303 (Fax)

HOME PAGE: http://www.brunel.ac.uk/depts/ecf/Staff/SpagnoloF/Main.htm

Zacharias Psaradakis

University of London - Economics, Mathematics and Statistics ( email )

7-15 Gresse Street
London, WC1E 7HX
United Kingdom
+44 20 7631 6415 (Phone)
+44 20 7631 6416 (Fax)

HOME PAGE: http://www.econ.bbk.ac.uk/faculty/psaradakis/

Martín Sola

Universidad Torcuato Di Tella ( email )

Minones 2159
1428 Buenos Aires, 1428
Argentina
5411 4784 0080 (Phone)
5411 4784 9807 (Fax)

University of London - Economics, Mathematics and Statistics ( email )

Malet Street
London, WC1E 7HX
United Kingdom
+44 20 7631 6411 (Phone)
+44 20 7631 6416 (Fax)

HOME PAGE: http://www.econ.bbk.ac.uk/faculty/sola/

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