A re-examination of the predicting power of forward premia
Applied Financial Economics, 2005, vol. 15, issue 17, 1219-1225
The paper proposes that the spot exchange rate consist of two parts. Important information content is with its underlying movement, in accordance with the development in the economy and the adjustment in economic activity. The paper then extracts the underlying movement from the spot exchange rate using the state space method and the frequency domain method. The extracted component is persistent as expected, catching trend movement and matching the statistical characteristics of the forward premium to some degree. Based on the results, the paper is able to reject the finding in many previous studies that the forward premium predicts the future spot rate in a completely wrong way. The paper concludes that the forward premium does not help explain the future spot rate as its most feasible result.
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