Abstract
The hypothesis that the forward rate is an unbiased predictor of the future spot rate has been questioned time and again. In majority of the cases empirical evidence suggests that forward rates are neither efficient nor rational forecasts of future spot rates. The rejection of the forward rate unbiasedness hypothesis can be attributed to a misspecified theoretical model. In this paper we consider the misspecification to be in the form of exclusion of an explanatory variable, the risk premium. We test the unbiasedness hypothesis by including a time-varying risk premium using the GARCH-M representation. The risk premium is modeled by extending the Domowitz and Hakkio (1985) ARCH framework and by applying a GARCH (1, 1) specification. The exchange rates data are from January 1991 to February 2008 for U.K., Canada, Australia and Japan, the four advanced economies and for India, the emerging market economy, the data ranges from January 1999 to February 2008.
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