International Finance Exchange

Assessment Notes
Uncovered Interest Parity
From the Lecture:
– If an investor has the option between investing domestically and investing
internationally in a risk free asset (bond) then there will be an equilibrium
determined by the exchange rate.
– The return on the domestic bond will be 1+i
– The return on the international bond will be 1/St (1+i*); hence in the future
when convereted back to domestic currency this will be (Et (St+k)/St) (1+i*)
– Now, because if 1+I >(Et (St+k)/St) (1+i*), the domestic bond is better value,
the market will invest in the domestic bond increasing the price (lowering the
return), and if (Et (St+k)/St) (1+i*)>1+I then the market will invest in the
international bond.
– As a result, this creates an equilibrium where 1+I = (Et (St+k)/St) (1+i*)
○ Note however that this is not arbitrage (but rather based on
speculation of the future exchange rate
– This is the uncovered interest rate parity
– Also, (Et (St+k)/St) (1+i*) = 1 + (Et (St+k)-St)/ St = 1 + Δ St+k
– So in equilibrium (1+i) = (1 + Δ St+k)(1+i*)
○ Using approximations (see lecture slide on approximations – will need
to include in assignment!) this means that Δ St+k = i-i*
– The assumptions that underlie this theory are:
○ Risk neutral investors with rational expectations
○ Can invest in the domestic interest rate of i for k periods, or in the
international interest rate of i* for k periods
○ The exchange rate is quoted using the direct method
○ More?

Covered Interest Parity

From the lecture:
– The covered interest rate parity assumes that investors know exactly what Et
(St+k) is because they use the futures markets.
– That is Ft,t+k = Et (St+k).
– This would make the equation of (Ft-St)/St = it-it*
○ Note, this (unlike the uncovered interest parity) creates an arbitrage
opportunity because there is an exact value for the expectations of the
future – the futures price
– Assumptions:
○ Same assumptions from uncovered interest rate parity
 ○ That the covered interest rate parity assumes that investors know
exactly what Et (St+k) is because they use the futures markets
○ That the futures markets only reflect the expectation of future spot
prices.
○ More?
– Also note that due to the Siegel Paradox (will need to explain in assignment),
this is expressed using logarithms

FRUH
From the Lecture:
– The FRUH says that the future/forward’s price will fully reflect future
expectations of the spot rate (i.e. it is efficient)
– This means that Et (St+k) = Ft,t+k
– And hence St+k = Ft,t+k + ut+k
○ Where Et(ut+k)= 0
○ ut+k is uncorrelated with other information
 although, it need not be uncorrelated

From Engel (1996):

– Hodrick, Robert J., 1987, The empirical evidence on the efficiency of forward
and futures foreign exchange markets (Harwood, Char), first discovered that
there was a large conditional bias if the forward rate was used to predict the
future spot rate of exchange.
– Findings of a beta not equal to 1 and negative is a “robust finding.” This is
demonstrated by many sources of empirical evidence:
○ Backus, David, Allan Gregory and Chris Telmer, 1993, Accounting for
forward rates in markets for foreign currency, Journal of Finance 48,
1887-1908 → Found that for one month forward rates on corresponding
spot rates on the Canadian dollar, French franc, DM, Yen and pound
between 1974 and 1990 that the beta is significantly less than one and
negative. They further state that this is consistent for the Lira, the
Belgium Franc, guilder and Swiss franc and even true when non US
dollar cross rates are used.
○ Mark, Nelson, Yangru Wu and Weike Hai, 1993, Understanding spot and
forward exchange rate regressions (Ohio State University, Columbus,
OH) confirm this finding with evidence on the Franc, Yen and Pound
between 1976 to 1988.
○ Froot, Kenneth A. and Jeffrey A. Frankel, 1989, Forward discount bias: Is
it an exchange risk premium?, Quarterly Journal of Economics 104,
139-161 find that beta is significantly less than zero for the pound,
yen, swiss franc and mark between 1976 and 1985.
○ Baillie, Richard T., 1989, Tests of rational expectations and market
efficiency, Econometric Reviews 8, 151-186 suggests bivariate VARs for
St - St-1 and Ft - St and finds that the forward rate is not an unbiased
predictor of the spot rate for mark/dollar between 1973 and 1980.
○ Bekaert, Geert, 1992, The time-variation of expected returns and
volatility in foreign exchange markets, Journal of Business and
Economics Statistics, forthcoming, confirms Baillie (1989) for the Mark,
Pound and Yen to the dollar between 1975 and 1991.
○ McCallum, Bennett T., 1994, A reconsideration of the uncovered
interest parity relationship, Journal of Monetary Economics 33, 105-132
finds a beta of -4 for the yen, mark and pound against the dollar
between 1978 and 1990.
○ Byers, J.D. and D.A. Peel, 1991, Some evidence on the efficiency of the
sterling-dollar and sterling-franc forward exchange rates in the
interwar period, Economics Letters 35, 317-322; and MacDonald,
Ronald and Mark P. Taylor, 1990, The term structure of forward foreign
exchange premia: The inter-war experience, The Manchester School of
Economics and Social Studies 58, 54-65; MacDonald, Ronald and Mark
P. Taylor, 1991, Risk, efficiency and speculation in the 1920s foreign
exchange market: An overlapping data analysis, Weltwirtschaftliches
Archiv 127, 500-523 find that the beta is negative in the 1920s
between the pound/ French franc and the dollar.
○ McFarland, James W., Patrick C. McMahon, and Yerima Ngama, 1994,
Forward exchange rates and expectations during the 1920s: A re-
examination of the evidence, Journal of International Finance 13, 627-
636 find that the beta is less than 1 but not negative (and hence reject
the null hypothesis) for the pound, French frank, dollar, Belgian franc
and lira in the 1920s.
○ Flood, Robert P. and Andrew K. Rose, 1994, Fixes: Of the forward
discount puzzle, Working paper no. 4928 (National Bureau of Economic
Research, Cambridge, MA) find a negative beta for floating exchange
rates for the AUD, CAD,French Franc, Mark, Yen, Swiss Franc and Pound
between 1981 ad 1984. However, when they conduct the same
analysis of Belgian Franc, Krone, Punt, Lira and guilder against the
mark (which are fixed exchange rates) for the same period, they
estimate a beta of 0.58…although when they re-estimate it by omitting
the dates when exchange rate realignments occur they get a beta of
0.25.
○ Others include:
 Choi, Seugmook and Benjamin J.C. Kim, 1991, Monetary policy
regime changes and the risk premium in foreign exchange
markets: A GARCH application, Economics Letters 37, 447-452.
 Chrystal, K. Alec and Daniel L. Thornton, 1988, On the
information content of spot and forward exchange rates, Journal
of International Money and Finance 7, 321-330.
 Kearney, Colm and Ronald MacDonald, 1991, Efficiency in the
forward foreign exchange market: Weekly tests of the
Australian/U.S. dollar exchange rate, January 1984-March 1987,
Economic Record 67, 237-242.
 Marston, Richard C., 1993, Interest differentials under fixed and
flexible exchange rates: The effects of capital controls and
exchange risk, In: Michael D. Bordo and Barry Eichengreen, eds.,
A retrospective on the Bretton Woods system: Lessons for
 international monetary reform (University of Chicago Press,
Chicago, IL).
 Pittis, Nikitas, 1992, Causes of the forward bias: Non-rational
expectations versus risk premia, Applied Economics 24, 317-
325.
 Bekaert, Geert and Robert J. Hodrick, 1993, On biases in the
measurement of foreign exchange risk premiums, Journal of
International Money and Finance 12, 115-138.
– Arguments against:
○ Mayfield, E. Scott and Robert G. Murphy, 1992, Interest rate parity and
the exchange risk premium: Evidence from panel data, Economics
Letters 40, 319-324, however do a regression and include a common
time varying intercept and find that they can no longer reject the null
hypothesis.
○ Taylor (1989) – see bellow
○ Cornell, Bradford, 1989, The impact of data errors on measurement of
the foreign exchange risk premium, Journal of International Money and
Finance 8, 147-157 suggests that studies have been misaligned by not
including transaction costs (they usually just take averages of bid and
ask values) and they don’t correctly align the forward dates with the
spot rates. As a result, he reivenstigates the Fama (1984) data set and
finds that you cannot reject the null hypothesis for CAD/USD however
you can for French Franc, Pound, Yen, guilder relative to the USD.
 Fama, Eugene, 1984, Forward and spot exchange rates, Journal
of Monetary Economics 14, 319-338.
○ The example the lecturer did in class
– With a risk premium:
○ Bekaert, Geert, 1992, The time-variation of expected returns and
volatility in foreign exchange markets, Journal of Business and
Economics Statistics, forthcoming.
○ Canova, Fabio and Takatoshi ito, 1991, The time-series properties of
the risk premium in the yen/dollar exchange market, Journal of Applied
Econometrics 6, 125-142.
○ Canova, Fabio and Jane Marrinan, 1993, Profits, risk and uncertainty in
foreign exchange markets, Journal of Monetary Economics 32, 259-286.
○ Cheung, Yin-Wong, 1993, Exchange rate risk premiums, Journal of
International Money and Finance 12, 182-194.
○ Mark, Nelson, Yangru Wu and Weike Hai, 1993, Understanding spot and
forward exchange rate regressions (Ohio State University, Columbus,
OH).
 These studies conduct a regression with a risk premium of rpt
however they all find that the risk preimium varies a lot,
indicating that dollar assets swing from periods in which they
regard the domestic currency as safe to periods where they
regard the domestic currency unsafe!
 Main problem with rpt is that it still relies on ‘rational investors’
and can suffer from sampling errors in small samples
From Taylor (1995):
– The uncovered interest rate parity:
○ Is the corner stone parity condition for testing foreign exchange market
efficiency
○ It says that if the risk neutral hypothesis holds, then it assumes that
the expected foreign exchange gain from holding one currency must
exactly offset the expected opportunity cost of holding another
currency. That is:
Δ St+k = i-i*
– Testing for efficiency:
○ Early tests such as POOLE, WILLIAM. "Speculative Prices as Random
Walks: An Analysis of Ten Time Series of Flex- ible Exchange Rates,"
Southern Econ. J., Apr. 1967, 33(2), pp. 468-78, tested efficiency by
testing for ‘randomness’ or ‘random walks.’ However, generally the
random walk principle is inconsistent with the interest parity principle
as random walks only occur when the nominal interest rate differential
is identical to a constant and there are rational expectations.
 This was proved by OBSTFELD, MAURICE. "Exchange Rates,
Inflation, and the Sterilization Problem: Germany 1975- 1981,"
Europ. Econ. Rev., Mar./Apr. 1983, 21(1/2), pp. 161-89.
○ Another way to test for efficiency is to test for the profitability of filter
rules or trading rules (e.g. buying a currency whenever it rises j
percent above its most recent trough and selling the currency when-
ever it falls j percent below its most re- cent peak). A number of
studies do however prove that simple filter rules have been profitable,
although it is not always clear of the filter rule size to be chose ex ante:
 DOOLEY, MICHAEL P. AND SHAFER, JEFFREY R. "Analysis of Short-
run Exchange Rate Behavior: Mar. 1973 to 1981," in Exchange
rate and trade instability. Eds.: David Bigman and Teizo Taya.
Cambridge, MA: Ballinger, 1983, pp. 43-69.
 LEVICH, RICHARD M. AND THOMAS, LEE R. "The Significance of
Technical Trading-Rule Profits in the Foreign Exchange Market: A
Bootstrap Approach," J. Int. Money Finance, Oct. 1993, 12(5), pp.
451-74.
 ENGEL, CHARLES AND HAMILTON, JAMES D. "Long Swings in the
Dollar: Are They in the Data and Do Markets Know It?" Amer.
Econ. Rev., Sept. 1990, 80(4), pp. 689-713.
○ The most common way to test efficiency (of exchange rates) is through
regression based analysis of spot and forward exchange rates…hence
the covered interest rate parity.
○ The uncovered interest rate parity can be tested by estimating the
regression of:
○ When you run the regression you should get a beta of 1.
 Initially evidence proved to find a beta of close to 1 - FRENKEL,
JACOB A. "A Monetary Approach to the Exchange Rate: Doctrinal
Aspects and Empiri- cal Evidence," Scand. J. Econ., Mar. 1976,
78(2), pp. 200-24. However, this was realised to be wrong
because it didn’t take into account the non-stationarity (i.e. the
ordinary method of the sum of least squares will drive beta
towards unity) – as a result, regression tests have become more
sophisticated…
 However, this new evidence has been unfavourable - Fama,
Eugene, 1984, Forward and spot exchange rates, Journal of
Monetary Economics 14, 319-338.
 Infact – they are usually closer to minus unity! This is referred to
as the forward discount bais - FROOT, KENNETH A. AND THALER,
RICHARD H. "Anomalies: Foreign Exchange," J. Econ. Per-
spectives, Summer 1990, 4(2), pp. 179-92
• This means that the more the forward currency is at a
premium, the less the home currency is expected to
depreciate.
 Further adjustments to the regression included considering a risk
premium (i.e. assuming risk aversion rather than risk neutral
behaviour). This is usually done by taking the risk premium as a
function of the variance of the forecast errors or exchange rate
movements:
• FRANKEL, JEFFREY A. "In Search of the Exchange Risk Pre-
mium: A Six-Currency Test Assuming Mean- Variance
Optimization," J. Int. Money Finance, Dec. 1982b, 1(3), pp.
255-74; reprinted in JEF- FREY FRANKEL 1993a, pp. 219-
34.
• DOMOWITZ, IAN AND HAKKIO, CRAIG S. "Condi- tional
Variance and the Risk Premium in the Foreign Exchange
Market," J. Int. Econ., Aug. 1985, 19(1/2), pp. 47-66.
• GIOVANNINI, ALBERTO AND JORION, PHILIPPE. "The Time
Variation of Risk and Return in the Foreign Exchange and
Stock Markets," J. Fi- nance, June 1989, 44(2), pp. 307-25.
• HANSEN, LARS P. AND HODRICK, ROBERT J. "Risk-Averse
Speculation in the Forward Foreign Exchange Market: An
Econometric Analysis of Linear Models," in JACOB
FRENKEL, ed. 1983, pp. 113-42. however used a ‘latent
variable formulation’ of the risk premium.
○ All of these have shown mixed (but not promising)
results when applied to data sets.
 A further adjustment is to assume the error is in the ‘rational
expectations’ assumption made by the uncovered interest rate
 parity. This is within the field of bahavioural finance (which has
come into popularity with the recent credit crunch crisis). Some
examples include:
• The peso problem (where agents attach a small
probability to a large change in the economic
fundamentals, which causes a skew in the distribution of
forecast errors even if agents' expectations are rational) –
ROGOFF, KENNETH. "Expectations and Exchange Rate
Volatility." Unpublished Ph.D. thesis, Massachusetts
Institute of Technology, 1979.
• Rational Bubbles – LEWIS, KAREN K. "Changing Beliefs and
Systematic Ra- tional Forecast Errors with Evidence from
Foreign Exchange," Amer. Econ. Rev., Sept. 1989, 79(4),
pp. 621-36.
• Learning about regime shifts – LEWIS, KAREN K.
"Changing Beliefs and Systematic Ra- tional Forecast
Errors with Evidence from Foreign Exchange," Amer. Econ.
Rev., Sept. 1989, 79(4), pp. 621-36.
• Inefficient information processing – BILSON, JOHN F. 0.
"The 'Speculative Efficiency' Hypothesis," J. Bus., July
1981, 54(3), pp. 435-51.
 The main problem with empirical tests is however that it relies
on the assumption ceteris paribus (i.e. that the other
components are correct). However, the generally accepted
conclusion is that both risk aversion and a lack of rational
expectations affect the uncovered interest rate parity
• MCCALLUM, BENNETT T. "A Reconsideration of the
Uncovered Interest Rate Parity Relation- ship," J. Monet.
Econ., Feb. 1994, 33(1), pp. 105-32.
• Taylor (1995)
– The covered interest rate Parity:
○ Says that if there are no barriers to arbitrage across international
markets, then the interest differential on similar assets should be zero
(adjusted for the covering in the forward currency exchange market at
the maturity of the underlying assets), so that:
(it-it*) - (Ft-St) = 0
○ Evidence is however quite supportive of the covered interest rate
parity:
 FRENKEL, JACOB A. AND LEVICH, RICHARD M. "Covered Interest
Arbitrage: Unexploited Prof- its?" J. Polit. Econ., Apr. 1975, 83(2),
pp. 325- 38; FRENKEL, JACOB A. AND LEVICH, RICHARD M.
"Transaction Costs and Interest Arbitrage: Tranquil versus
Turbulent Periods," J. PoUit. Econ., Dec. 1977, 85(6), pp. 1207-
 24. – find that it is consistent for Euro-deposit rates, but not so
much for treasury bills
 CLINTON, KEVIN. "Transactions Costs and Cov- ered Interest
Arbitrage: Theory and Evidence, J. Polit. Econ., Apr. 1988, 96(2),
pp. 358-70.
 TAYLOR, MARK P. "Covered Interest Parity: A High-Frequency,
High-Quality Data Study," Economica, Nov. 1987, 54(216), pp.
429-38. TAYLOR, MARK P. "Covered Interest Arbitrage and Market
Turbulence," Econ. J., June 1989, 99(396), pp. 376-91.

Does the FRUH hold?

From the lecture:
– To test if the FRUH holds, you form the regression:
St+k = α + β Ft,t+k + ut+k
○ And then test for α = 0 and β = 1
– Early evidence by Cornell (1977), Levich (1979) and Frenkel (1980) do this
and generally find support for the FRUH
○ However, is testing the above equation the best thing to do?
– A better way is to form the regression:
ΔSt+k = α + β (Ft,t+k - St) + ut+k
○ And then test for α = 0 and β = 1
– The textbooks, Engel (1996) and Taylor (1995) give an overview of this and
the evidence and find no support for the FRUH → use these sources a lot!
○ The evidence finds that the estimates of β are closer to minus unity
rather than unity!
– Other evidence:
○ However, Cointegration tests to favour the model a bit more – although
Zivot (2000) discusses some of the problems with cointegration tests
○ Huisman et al (1998) find support during periods where the forward
premium is large.
– Perhaps the reason is because we have made something wrong with the
assumptions. Lets now assume investors are risk averse (and not risk
neutral). This makes:
Et (St+k) + rpt = Ft,t+k
○ Where rpt is a risk premium
– Hence, with rational expectations, we get:
Ft,t+k = St+k + rpt + ut+k
○ Now, we assume that the risk premium is a function of the forward rate
and spot rate:
rpt = α + β (Ft - St)
○ And then, when this is subbed into the original formula:
Ft,t+k - St+k = α1 + β1 (Ft - St) + ut+k
○ Notice the similarities with the familiar:
 ΔSt+k = α2 + β2 (Ft,t+k - St) + ut+k
○ This shows us why β2 doesn’t equal zero!
– Fama (1984) explains this:
○ We know that Ft,t+k - St+k equals the risk premium plus the error
○ We also know that Ft,t+k - St+k is a function of the of the forward
premium
○ So, if β1 doesn’t equal zero, the risk premium is present in Ft,t+k - St+k
○ An if β2 doesn’t equal zero the forward rate contains predictive
information about the future spot rate
○ We know that:

○ Now, if the covariance is zero, we know that β1+ β2 =1. However, if the
covariance doesn’t equal zero, simple interpretation is lost. As a result,
under rational expectations, the FRUH could fail because of a highly
time-varying risk premium…however this seems unlikely.
– Even if we assume that investors value the FRUH in real terms
○ This makes:

○ Now, assuming that the variables are log normally distributed, this can
be written as:

○ These last two terms are Jensen’s inequalities and implies that:

– However, unfortunately this is not enough to explain the failure of the FRUH.

Other Journal Articles – Recommended:

Dwyer (1992):
– Demonstrates that contrary to the assertions of the following, asset prices
determined in an efficient market can be co-integrated:
○ GRANGER, C.W., ‘Developments in the Study of Cointegrated
Variables,’ Oxford Bulletin of Economics and Statistics, August 1986,
48: 213-228 at 218.
 ○ BAILLIE,R ICHARDT ., ANDT IM BOLLERSLEV‘C, ommon Stochastic
Trends in a System of Exchange Rates,’ Journal of Finance, March 1989,
44: 167- 181.
○ HAKKIO, CRAIG S., AND MARK RUSH, ‘Market Efficiency and
Cointegration: An Application to the Sterling and Deutschemark
Exchange Markets,’ Journal of International Money and Finance,
1989,8: 75-88.
○ MACDONALD, RONALD, and MARK P. TAYLOR, ‘Foreign Exchange Market
Efficiency and Cointegration: Some Evidence from the Recent
Float,‘Economic Letters, 1989,29: 63-68.
○ COLEMAN, MARK, ‘Cointegration-Based Tests of Daily Foreign Exchange
Market Efficiency,’ Economic Letters, 1990, 32: 53-59.
○ BOOTH, GEOFFREYG ., AND CHOWDHURYM USTAFA, ‘Long-Run
Dynamics of Black and Official Exchange Rates,’ Journal of
Internationul Money and Finance, September 1991, 10:392-405.
○ COPELAND, LAURENCE S., ‘Cointegration Tests with Daily Exchange
Rate Data,’ Oxford Bulletin of Economics and Statistics, May 1991:
185-198.
– They specifically demonstrate how this can apply to exchange rates and
forward exchange rates.

Elliot (1999):
– The FRUH states that the forward rate is an unbiased estimator of the spot
rate in the future.
– The usual way to test this is to see whether the forward premium in logs (Ft, k
- St) is an unbiased estimator of the ex-post depreciator (St+ k - St).
– Because evidence tends to frequently reject this, it is referred to as a ‘puzzle’
– This puzzle suggests the opportunity of unexploited profits (arbitrage).
○ This idea is confirmed in:
 FROOT, KENNETH A. AND THALER, RICHARD H. "Anomalies:
Foreign Exchange," J. Econ. Per- spectives, Summer 1990, 4(2),
pp. 179-92
 Lewis, K.K., 1995. Puzzles in international Þnance markets. In:
Grossman, G., Rogo¤, K. (Eds.), Handbook of International
Economics, North Holland, Amsterdam, pp. 1913Ð1971.
– Most sources have blamed the risk premium for this puzzle, although
regression tends to require risk premiums that seem way too high - Bekaert,
G., 1995. The time variation of expected returns and volatility in foreign-
exchange markets. Journal of Business and Economic Statistics 13, 397Ð408.
– As a result, this study ignores the regression and takes the data set from Ito,
T., 1990. Foreign exchange rate expectations: Micro survey data. American
Economic Review 80, 434-449. Instead, its goes straight to the arbitrage
profits that would be available from this puzzle.
– Elliot finds that although the survey data does create a puzzle, the profits are
mostly small profits from trading rules. Furthermore, these profits are highly
variable, so there is significant risk in using one of these trading strategies.
– However, he concludes that the evidence indicates that there is more going
on in the models of exchange rates than simply static expectations with
random noise.
Fama (1984):
– They restate everything that has been said so far about the FRUH.
– They create a model to test it – in particular how the premium of the forward
rate relates to the spot rate.
– The discover large positive autocorrelations of the difference between the
forward rate and the spot rate, indicating a variation in either the premium (F
– S) or in the assessment of the expected changes in the spot rate.
– They also discover negative slope coefficients in the regressions of St+k – St
or Ft – St and as a result conclude that the variance of the premium is much
larger than the variance of the expected value of the spot change.

Hakkio (1989):
– After lots of evidence to discover whether exchange markets are efficient,
they decide to test it again using a new method (at the time) which involves
cointegration.
– States that there are generally 2 ways of testing market efficiency:
○ Method 1 - involves regressing the future spot rate on the forward rate
so that;
– St+1 = a + bFt + e
 They then hope that a = 0 and b = 1
 Used by FRENKEL, JACOB A. "A Monetary Approach to the
Exchange Rate: Doctrinal Aspects and Empiri- cal Evidence,"
Scand. J. Econ., Mar. 1976, 78(2), pp. 200-24; FRENKEL, JACOB A.
AND LEVICH, RICHARD M. "Transaction Costs and Interest
Arbitrage: Tranquil versus Turbulent Periods," J. PoUit. Econ.,
Dec. 1977, 85(6), pp. 1207-24
○ Method 2 – involves regressing the rate of depreciation on the forward
premium so that:
St+1 - St= a + b(Ft – St) + e
 And hope that a = 0 and b = 1
 Used by: BILSON, JOHN, ‘The Speculative Efficiency
Hypothesis,‘Journulof Business, July 1981, 54: 435-432.; CUMBY,
ROBERT E., AND MAURICE OBSTFELD, ‘Exchange Rate
Expectations and Sominal Interest Rate Differentials: A Test of
the Fisher Hypothesis,‘JournalofFinance, June 1981,36: 697-703;
GE~%;E, JOHN F., AND EDGAR L. FEIGE, ‘Some Joint Tests of the
Efficiency of Markets for Foreign Exchange,’ Review of
Economics and Statistics, August 1979, 61: 334-341; H.ANSEN,
LARS P., AND ROBERT J. HODRICK;, ‘Forward Exchange Rates as
Optimal Predictors of Future Spot Rates: An Econometric
Analysis,’ Journal of Political Economy, October 1980, 88:829-
853; H~ASG, ROGER, ‘Some Alternative Tests of Forward
Exchange Rates as Predictors of Future Spot Rates,’ Journal of
International Money ond Finance, August 1984, 3: 153-168.
– The second method is usually preferred because the spot and forward rates in
the first are non stationary (hence there can be trend), however results have
shown that beta is generally -1!
– However a 3rd method has evolved.
– ENGLE, ROBERT, AND CLIVE W.J. GR.INGER, ‘Cointegration and Error
Correction: Representation, Estimation, and Testing,’ Econometrica, March
 1987, 55: 251-276.and GRAXER, CLIVE W.J., ‘Developments in the Study of
Cointegrated Economic Variables,’ Ox-rd Bulletin of Economics and Statistics,
August 1986, 48: 213-228 showed that 2 prices from a pair of efficient
markets cannot be cointegrated.
– Hakkio hence applies this to German and UK spot rates, aswell as between
spot rates and future rates within those countries.
– Their results are that the German and UK spot rates are not cointegrated
(suggesting efficiency), The Uk future spot and forward rates are not
cointegrated (efficient).
– However they then adjust their results for error correction equations and
suddenly there is cointegration and hence markets are inefficient.

Huisman (1998):
– The uncovered interest rate parity says that the return on a domestic
currency deposit equals the expected return from converting the domestic
currency into the foreign currency, investing it in a foreign deposit and then
converting the proceeds back into the domestic currency at the future
expected exchange rate.
– This implies that the forward premium is an unbiased predictor of the change
in the spot exchange rate.
– However, after many investigations, data shows that the UIP doesn’t hold
– This paper uses a ‘panel model’ to test the UIP/FRUH and finds that beta is
not -1, but only about 0.5 – so not unity, but not as bad as minus unity
– Then they distinguish between normal and abnormal observations where
normal observations are determined by the average size of the forward
premiums over all exchange rates.
○ Bilson, J.F.O., 1981. The speculative efficiency hypothesis. J. Bus. 54,
435-451; Flood, R.P., Rose, A.K., 1994. Fixes: of the forward discount
puzzle. NBER Working Paper, 4928, and Flood, R.P., Taylor, M.P., 1996.
Exchange rate economics: what’s wrong with the conventional macro
approach. In: Frankel, J.A., Galli, G., Giovannini, A. (Eds.), The
Microstructure of Foreign Exchange Markets. NBER, pp. 261-294. Were
the first to suggest to distinguish between normal and abnormal
observations – however bilson discovers that abnormal observations
are actually more inkeeping with the UIP!
– When they do this, they find that the UIP almost perfectly holds in periods
where the average cross-sectional forward premium is large. But no success
for small premiums.
○ This suggests the peso problem (see above), as suggested by Baldwin,
R.E., 1990. Re-interpreting the failure of foreign exchange market
efficiency tests: small transaction costs, big hysteresis bands. CEPR
Discussion Paper, 407.

Mark (1998):
– Tries to explain the Forward Premium Bias using the standard representative
agent intertemporal asset pricing model and a model of noise trading.
○ The standard representative agent intertemporal asset pricing model is
the normal model we have been using with a risk premium
○ The noise trader model is taken from De Long et al (1990). This model
combines rational investors with noise traders. The model shows that
 the more noise traders there are, the more risky it is for rational
arbitrageurs to offset this position so there is a tendancy for the
market to be pushed away from its efficient level.
– There analysis finds that the standard representative agent intertemporal
asset pricing model has very little empirical evidence, despite its intuitive
attractions. Hence the move towards the Behavioural finance explanations –
but there is much conjecture about these theories in general, so they cannot
yet explain the Forward premium bias.

Taylor (1989):
– Defines UIP and CIP
– They then investigate the UIP and the CIP during periods of ‘turbulance’ or
introduced news that is known to significantly effect the market. They also
make explicit allowances for costs such as brokerage, bid-offer spread and
the formulae used by market participants.
– They discover that:
○ Small (but potentially exploitable) arbitrage opportunies to emerge
during periods of turbulence, however during relatively calm periods
(the control) there are no exploitable arbitrage opportunities
○ The degree of efficiency of the markets appears to have increased over
the 20 year period they examined (1967-1987)
○ That few (if anyP arbitrage opportunies arise in shorter maturities,
whilst small but significant profitable opportunities arise in longer
maturities during turbulent periods.
 This suggests that this is due to credit limits and liquidity
constraints.
– Their results therefore support the CIP!

Zivot (2000):
– Discusses the large amount of literature of the FRUH
– Says that since Hakkio and Rush (1989) that efficiency has to be tested by
cointegrating St+1 and ft using a cointegration vector of (1,-1).
– However, the paper explains some pitfalls in modeling the cointegarted
behaviour of spot and forward rates.

My own articles (may not be that relevant):

Bekeart (2007):
– Notes that although there is a lot of evidence against the UIP, that recent
evidence has found that this is not by as much as first calculated. For
example:
○ Bekaert, G., Hodrick, R.J., 2001. Expectations hypotheses tests. Journal
of Finance 56 (4), 1357e1394; and Baillie, R.T., Bollerslev, T., 2000. The
forward premium anomaly is not as bad as you think. Journal of
International Money and Finance 19 (4), 471e488. – argue that doubtful
statistical inference was the problem
○ Chinn, M.D., Meredith, G., 2004. Monetary policy and long-horizon
uncovered interest parity. IMF staff papers 51 (3), 409e430. – argue
that the UIP holds better at long horizons
○ Chaboud, A.P., Wright, J.H., 2005. Uncovered interest parity: it works,
but not for long. Journal of International Economics 66 (2), 349e362. –
 finds that there is support for the UIP for overnight exchange rate
movements and interest-rate differentials.
– He also notes that people have long ignored this puzzle (i.e. they usually
assume the UIP holds!)
– As all of this evidence is totally conflicting, Bekaert thinks it is necessary to
reinvestigate the UIP. He does this by examining the UIP at both long and
short intervals using a vector autoregression (VAR).
– He discovers that:
○ Evidence is totally mixed – it depends on which currency you use
○ That it is not time dependant – long and short term deviate the same
amount
– This evidence is largely consistent with that of Bekaert, G., Hodrick, R.J.,
2001. Expectations hypotheses tests. Journal of Finance 56 (4), 1357e1394;
and Baillie, R.T., Bollerslev, T., 2000. The forward premium anomaly is not as
bad as you think. Journal of International Money and Finance 19 (4), 471e488.

Chinn 2008:
– Investigates exchange rate movements in general.
– Evaluates the key exchange rate prediction models of:
○ The random walk model formulated by Frankel JA. 1979. On the mark:
a theory of floating exchange rates based on real interest differentials.
American Economic Review 69: 610–622, of the Dornbusch R. 1976.
Expectations and exchange rate dynamics. Journal of Political Economy
84: 1161–1176 model.
○ The UIP
○ The Gourinchas P-O, Rey H. 2005. International financial adjustment.
NBER Working Paper No. 11155 - a log-linearize model based on net
exports to net foreign assets variable around its steady-state value
 For the purposes of this we will focus on the 2nd one
– Find that evidence doesn’t prove correct and hence suggest a new model.

Felmingham (2005):
– This paper tests whether the UIP and the CIP hold between the Aus and Us
dollar between 1985 and 2000 in the 90 day and 180 day forward markets.
○ To overcome the problem of nonstationarity data, comparatively recent
estimation techniques are introduced and applied. The UIP model is
modified to allow for the presence of a time-varying risk premium in
the foreign exchange market.
– States that the CIP asserts that the forward premium on foreign exchange
must equal the difference between domestic and foreign interest rates on
securities of the same term to maturity provided that domestic and foreign
bonds are both free of default risk. A second requirement for CIP is that
speculative trading should bring the forward premium (discount) into equality
with expected depreciation (appreciation) of the domestic currency.
– States that the UIP underpins a number of models of the balance of payments
and the exchange rate and in terms of policy implication if the UIP condition
holds sterilised foreign exchange market intervention is ineffective. The
failure of UIP does mean that sterilised intervention can have real effects and
that the portfolio balance model of exchange rate intervention may be
preferred to the monetary models of the balance of payments.
 – Results:
○ That the CIP holds for both 90 and 180 day forwards
○ That the UIP doesn’t hold between 1985 and 1991, however holds
between 1992 and 2000.
– Perhaps this success in because the Australian economy is a small open
economy and yet hthe currency is the 5th most traded currency in the world

Kavussanos (2004):
– Applies the FRUH theory to freight OTC market.
– The results show that Forward Freight Agreements (FFA) for 1 and 2 month are
unbiased estimators of the spot rate, whilst 3 months Pacific routes are unbiased
predictors. However, for panamax atlantic routes there are biased.
– As a result – they conclude it totally depends on the product and market

Moosa (2004):
-Post Keynesian view of Interest rate parity

Nikolaou (2006):
– States the usual on UIP
– Takes a new approach by using the option market instead of the futures market – that
is they use options to create a synthetic forward position.
– The results confirm (replicate) the previous bias – that is, there is a synthetic option
bias puzzle aswell!
– This suggests that forward and options provide optimal exchange rate predictions
consistent with the notion of unbiasedness.

Razzak (2002);
– Same old stuff – finds that different markets and different maturities produce
different results

Widjaja (2004) and Shank (2002):

– Examine FRUH in emerging market of asia
– Find that:
○ There is still a bias

Sarantis (2006):
– Once again tests the UIP using traded volatility, a time varying risk premium and
hetrogenous expectations.
– Results:
○ There is support for an extended nonlinear UIP model
○ That high currency volatility causes unstable exchange rate paths…less like
for UIP to hold?