Abstract
In this paper, we use the largest exchange rate survey in Colombia to test for the rational expectations hypothesis, the presence of a time-varying risk premium and the accuracy of exchange rate forecasts. Our findings indicate that episodes of exchange rate appreciation preceded expectations of further appreciation in the short run, but were marked by depreciations in the long run. This reversal largely explains the stabilizing pattern of expectations. Additionally, we find that the forward discount differed from future exchange rate changes due to the rejection of the unbiasedness condition and to the presence of a time-varying risk premium. Finally, we find that only short run expectations were able to outperform a random walk process as well as models of extrapolative, adaptive, and regressive expectations. Long-run expectations, on the other hand, behaved poorly in terms of forecasting accuracy.
Highlights
The total currency turnover in global financial markets has dramatically increased since the end of the Bretton Woods system in the early 1970s
In this paper, we use the largest exchange rate survey in Colombia to test for the rational expectations hypothesis, the presence of a time-varying risk premium and the accuracy of exchange rate forecasts
We find that the forward discount differed from future exchange rate changes due to the rejection of the unbiasedness condition and to the presence of a time-varying risk premium
Summary
The total currency turnover in global financial markets has dramatically increased since the end of the Bretton Woods system in the early 1970s. There are numerous studies such as Lewis (1995), Bekaert (1996), Mark and Wu (1998), Carlson (1998), and Meredith and Ma (2002) that find statistical evidence of a currency risk premium Authors such as Nurkse (1944), Takagi (1991), and Frankel and Rose (1994) consider expectations to be highly volatile and unstable, and state that the influence of psychological factors may at times be overwhelming. We use a novel (and proprietary) survey conducted monthly by the Central Bank of Colombia during October 2003–August 2012 to test for the rational expectations hypothesis, the presence of a time-varying risk premium, and the accuracy of exchange rate forecasts.
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