International Finance Discussion Papers (IFDP)
November 1988
The Forward Exchange Rate Bias: A New Explanation
Ross Levine
Abstract:
Although the literature has devoted prodigious resources to investigating the risk premium explanation of the systematic time-varying discrepancies between forward and corresponding future spot exchange rates, empirical verification of the risk premium hypothesis has proven elusive. This paper tests an alternative explanation of the forward bias: the anticipated real exchange rate hypothesis. This hypothesis states that except for a constant risk premium, the predictable, time varying wedge between forward and expected future spot exchange rates is fully explained by the anticipated rate of change in the real exchange rate. The data do not reject this hypothesis. This suggests that the literature's almost singular concern with the risk premium explanation of the forward bias should be amended to include the effects of anticipated real exchange rate movements.
PDF: Full Paper
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