University of Washington - Department of Economics
A popular empirical topic in economics and finance is the investigation of financial market efficiency. A general characterization of market efficiency says that abnormal profits cannot be made based on currently available information (informationally efficient). In international finance many researchers have attempted to test whether the market for foreign currency is informationally efficient. Under the assumption that market participants are risk neutral and have rational expectations market efficiency implies that the current forward exchange rate, for delivery of foreign currency at some date in the future, is an unbiased predictor of the future spot exchange rate. This relationship is called the forward rate unbiasedness hypothesis (FRUH). Statistical tests of FRUH are complicated by the fact that both forward and spot exchange rates exhibit random walk behavior and that current forward rates and current spot rates appear to be cointegrated (i.e., share a common random walk component). In this paper, I investigate the relationship between tests of FRUH and models of cointegration between forward and spot exchange rates.