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An old debate in international monetary economics is whether the
forward exchange rate contains useful information about the future path
of the spot exchange rate. If the expected change in the exchange rate
equals the interest differential between the currencies, and the
difference between the spot and forward exchange rates `the forward
premium' equals the interest rate differential, the equilibrium forward
exchange rate established now in an efficient market for delivery of
foreign exchange n periods ahead should be the best available predictor
of the spot exchange rate realized n periods later. Numerous studies
show, however, that the forward rate is not the best predictor of the
future spot rate; indeed it tends to mispredict the direction of
subsequent spot rate changes. Some authors attribute this rejection of
the `simple efficiency hypothesis' to a risk premium and others to
inefficient information processing by market participants, but studies
using survey data on expected exchange rate changes indicate that the
risk premium cannot fully explain this phenomenon. Many economists
therefore dismiss the forward rate as containing little information
concerning subsequent spot rate movements. |