Structural change in the forward discount: Implications for the forward rate unbiasedness hypothesis

Georgios Sakoulis, Eric Zivot, Kyongwook Choi

Research output: Contribution to journalArticlepeer-review

21 Scopus citations

Abstract

It is a well-accepted empirical result that forward exchange rate unbiasedness is rejected in tests using the "differences regression" of the change in the logarithm of the spot exchange rate on the forward discount. We model the forward discount as an AR(1) process and argue that its persistence is exaggerated due to the presence of structural breaks. We show using a stochastic multiple break model that the forward discount persistence is substantially less if one allows for multiple structural breaks in the mean of the process. We argue that these breaks could be identified as monetary shocks to the central bank's reaction function. Using Monte Carlo simulations, we show that if we do not account for structural breaks that are present in the forward discount process, the forward discount coefficient in the "differences regression" is severely biased downward, away from its true value of 1.

Original languageEnglish
Pages (from-to)957-966
Number of pages10
JournalJournal of Empirical Finance
Volume17
Issue number5
DOIs
StatePublished - Dec 2010

Keywords

  • Exchange rates
  • Forward discount rate unbiased hypothesis
  • Structural changes

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