| The fundamental question of international finance of whether the forward rate can be used as an unbiased predictor of the future spot rate for a given currency is examined. Besides just looking at the long term equilibrium levels I devise econometric time series models to explain the short run dynamic adjustment of spot exchange rates towards their long run equilibrium level that is dictated by the Unbiased Forward Rate Hypothesis (UFRH).; Using daily data on spot, 1-, 3-, 6-, 9-, and 12-month forward rates for five currencies spanning over a five year period, I find supporting evidence for the UFRH in the long run, noting that this evidence is stronger when forward rates with shorter time horizons are used. On the other hand short run dynamic movements of the spot rates seem to be exogenous to the information contained in the term structure of the forward rates. Bivariate dynamic error correction models for spot and given time horizon forward rates suggest that any deviation from the long run equilibrium level will be corrected by the dynamic movement of a given forward rate and not a spot rate. Using multivariate error correction models, in which the vector of parameters included spot and 1-, 3-, 6-, 9-, and 12-month forward rates for each currency, did not improve forecasting performance of the models.; When testing whether the adjustment of exchange rates towards equilibrium levels should follow nonlinear form I find that among fifty error correction models, ten of those models fail the linear assumption suggesting that the speed of adjustment will depend on the magnitude of disequilibrium from the previous period. Using Jerome, Friedman's Multivariate Adaptive Regression Spline modeling I successfully removed the nonlinear structure of those models and in that way improved those dynamic models. |
