A re-examination of the unbiased forward rate hypothesis in the presence of multiple unknown structural breaks

Abstract

We test the Unbiased Forward Rate (UFR) hypothesis using new tests for cointegration developed by Hatemi-J (2008a) that allows for multiple unknown structural breaks. We analyse the Australian dollar (AUD), Euro (EUR), British pound (GBP) and Japanese yen (JPY) (versus the US dollar (USD)) spot rates and forward rates relationship during the period 5 January 1999 to 28 December 2006. We find that the UFR does hold when the effects of the unknown structural breaks are taken into account. The parameters that we obtained were close to unity; hence, taking into account transaction cost and the existence of a risk premium, earning arbitrage profits may still not be possible. Thus, the markets for these currencies may still be considered as efficient.

Notes

¹ It should be pointed out that Choi and Zivot (2007) provide evidence for multiple structural changes in the mean of the G7 countries’ forward rates.

² In addition to the literature cited earlier, see also Sercu et al. (2008), Diamandis et al. (2008), Chen (2010), Sekioua (2006), Wang (2005), Apergis and Eleftheriou (1997) as well as Ahmed and Ansari (1997).

³ According to the simulation experiments conducted by Hatemi-J (2008b), this information criterion performs well in situations where unit roots or Autoregressive Conditional Heteroscedastic (ARCH) effects prevail.

⁴ The Z_α and Z_t tests were originally introduced by Phillips (1987). It should be mentioned that Gabriel et al. (2002) suggested applying a Markov switching approach to test for cointegration in the presence of breaks.

⁵ The long-run variance is calculated by using an automatic bandwidth estimator and a prewhitened quadratic spectral kernel with a first-order autoregression for the prewhitening. For more details on this, see Andrews (1991) and Andrews and Monahan (1992).

⁶ See Gregory et al. (1996) for the power properties of tests for structural breaks in cointegrated relationships. See also Cook (2006) for the power tests for cointegration that are based on a single equation. For other multiple structural breaks procedures we refer the interested reader to Bai (1997) as well as Bai and Perron (1998, 2003).