Foreign Exchange Expectation Errors and Filtration Enlargements

Pedro L. P. Chaim and Márcio Laurini
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Pedro L. P. Chaim: FEA-RP/USP, Ribeirão Preto 14040-950, Brazil

Stats, 2019, vol. 2, issue 2, 1-16

Abstract: Extrapolations of future market forward rates are a better predictor of the 30-days ahead BRL-USD exchange rate than forecasts from the Central Bank Focus survey of Brazilian market participants. This is puzzling because market participants observe forward rates as they submit predictions, and thus these agents perform biased forecasts even though they have access to a set of unbiased forecasts, consistent with a martingale process for the exchange rate. We argue that this rational conundrum can be explained by a mechanism through which new information enlarges the information set (a filtration), changing the underlying measure and inducing a drift into the martingale process, turning the process into a strict local martingale and generating a forecast bias. Empirical results suggest that Focus survey forecasts indeed display characteristics of a strict local martingale, while spot exchange rates and forward rates are consistent with a martingale process.

Keywords: strict local martingales; filtration enlargement; foreign exchange markets; expectation errors (search for similar items in EconPapers)
JEL-codes: C1 C10 C11 C14 C15 C16 (search for similar items in EconPapers)
Date: 2019
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