Testing the Unbiased Forward Exchange Rate Hypothesis Using a Markov Switching Model and Instrumental Variables
Journal of Applied Econometrics, Forthcoming
Posted: 6 Dec 2004
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: Suggested Citation