Forward Exchange Rate Efficiency: A Cointegration and Error Correction Model Approach

Abstract

Forward rate unbiased hypothesis (FRUH) often generates mixed result in literatures. However, sophistication in econometric techniques has questioned the validity of traditional test for FRUH over the years. Consequently, this dissertation shows that exchange rates have unit root and are cointegrated with parameter near unity. Therefore, this makes regressing the level spot rate on the forward rate inappropriate. Furthermore, the forward premium regression becomes incomplete. Thus, an error correction model is proposed as a more suitable specification to test for FRUH. The results obtained did not provide support for FRUH. Additionally, evidence is shown that the forward premium puzzle has abated overtime and is subsample specific.