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TITLE:
The Forward Rate Unbiasedness Hypothesis Revisited: Evidence from a New Test

AUTHOR(S):
Natalya Delcoure, Louisiana Tech University
John T. Barkoulas, University of Tennessee
Christopher F. Baum, Boston College
Atreya Chakraborty, Charles River Associates

DOCUMENT TYPE: Article

ABSTRACT:
Under conditions of risk neutrality and rational expectations in the foreign exchange market, there should be a one-to-one relationship between the forward rate and the corresponding future spot rate. However, cointegration-based tests of the unbiasedness hypothesis of the forward rate have produced mixed findings. In order to exploit significant cross-sectional dependencies, we test the unbiasedness hypothesis using a new multivariate (panel) unit-root test, the Johansen likelihood ratio (JLR) test, which offers important methodological advantages over alternative standard panel unit-root tests. When applied to a data set of eight major currencies in the post-Bretton Woods era, the JLR test provides strong and robust evidence in support of a unitary cointegrating vector between forward and corresponding future spot rates. However, the orthogonality condition is satisfied only for three major currencies.