SOME TESTS OF THE RATIONAL EXPECTATIONS HYPOTHESIS IN THE FOREIGN EXCHANGE MARKET
| DOI | http://doi.org/10.1111/j.1467-9485.1983.tb01016.x |
| Published date | 01 August 1983 |
| Author | Ronald Macdonald |
| Date | 01 August 1983 |
Scorruh
Journal
01
Pobriml
Economy,
Vol.
30,
No.
3.
November
I983
8
1983
Swttuh
Economc
Society
SOME TESTS
OF
THE RATIONAL
EXPECTATIONS HYPOTHESIS IN
THE
FOREIGN EXCHANGE MARKET
RONALD
MACDONALD~
Loughborough
University
I
INTRODUCTTON
A
familiar proposition, from the literature on the efficiency of the foreign
exchange market, is that the forward exchange rate should be an unbiased
predictor of the future spot rate. This condition will hold if foreign exchange
market participants are rational, in the sense that they do not make systematic
forecasting errors, and there are no transaction costs or risk premia. However,
in periods dominated by new information the forward rate is unlikely to be a
particularly good predictor of the future spot exchange rate. This being
so
because in a rational market current prices should reflect all available
information, and, thus, any future changes are due purely to the arrival of
unanticipated events-the impact of “news”.
For example, the relationship between the quarterly spot exchange rate and
the lagged 90-day forward rate (i.e. the forward rate,
f:-
set last period as a
prediction of this periods exchange rate,
el),
for the French franc4J.S. dollar,
is
plotted in Figure
1.
As
is clear, the divergence between the two rates is quite
marked and this has been a feature of all exchange markets during the recent
floating experience. This divergence could be due to the existence of a risk
premium separating the forward rate from its expected future value. However,
Frankel (1978) has demonstrated that risk is completely diversifiable in the
foreign exchange market. Furthermore, empirical studies trying to capture the
existence of a risk premium have not been particularly successful.’ It would
thus seem plausible that this residual difference could be due to the impact of
unanticipated events on the exchange rate. In this paper an attempt is made to
provide a framework to test for the effects
of
this “news”.
I
would like
to
thank Mike
Artis
and Chris Green for their very helpful discussions and
comments on this paper. Useful comments were also received from Takao
Fujimoto,
David
Savage and participants
of
seminars at Loughborough and Manchester Universities.
The
usual
disclaimer applies.
A
longer version of this paper, containing more comprehensive empirical
results, may
be
obtained from the author
on
request.
See
for
example, Dooley and Isard (1979).
Date
of
receipt
of
final manuscript: 14 March 1983.
235
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Franc
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t
I
R.
MACDONALD
FRANCE
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ug
0--
-a
Spot
Rate. Perlod
t
W
Forward
Rate,
I:,
72
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79
80
Figure
1.
The forward exchange rate
as
a predictor of the future spot rate for the French franc,
quarterly, 1972
I1
to
1980
IV.
The outline
of
the paper is as follows. First, we consider the implications of
the rational expectations hypothesis for the foreign exchange market. In
Section I11 we test the proposition that the forward exchange rate is an
unbiased predictor of the future spot rate. It is argued that the choice of
estimating techniques is very important in such tests. Section
IV
considers the
effects
of
current and lagged values
of
news about relative money supplies.
Section VI considers an extension of this approach.
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