Are Foreign Excess Returns Always Predictable? Expectations Errors Revisited

Abstract

Using USD bilateral exchange rates in 1975-2009, we find that the strong predictability of foreign excess returns documented in the literature is mainly driven by a particular sample period. We first show that both the statistically significant positive serial dependence of excess returns in the entire sample and the very weak (mostly insignificant) positive serial dependence in the subsample excluding observations in 1980-87 are consistent with the prediction of the expectations errors alternative. We link this with the change in forecasting techniques over time and provide evidence that the behavior of the survey expectation is compatible with the market expectation.