Abstract
In an age of globalized finance, Forex market efficiency is particularly relevant as agents engage in arbitrage opportunities across international markets. This study tests the forward exchange rate unbiasedness hypothesis using more powerful tests such as the Zivot-Andrews single-break unit root and the KPSS stationarity (no unit root) tests to confirm that the USD/EUR spot and three-month forward rates are I(1) in nature. The study successfully employs the Engle-Granger cointegration analysis which identifies a stable long-run relationship between the spot and forward rates and generates an ECM model that is used to forecast the in-sample (historical) data. The study’s findings refute past conclusions that fail to identify the data’s I(1) nature and suggest that market efficiency is present in the long run but not necessarily in the short run.
Highlights
This study tests the forward exchange rate unbiasedness hypothesis using more powerful tests such as the Zivot-Andrews single-break unit root and the KPSS stationarity tests to confirm that the USD/EUR spot and three-month forward rates are I(1) in nature
This paper investigates the validity of the forward exchange rate unbiasedness hypothesis (FRUH) which is indicative of efficiency in the foreign exchange market using more powerful unit root and no unit root tests
This study shows that the spot and three-month forward exchange rates are I(1) processes using the more powerful KPPS stationarity test and the Zivot Andrews single break unit root test
Summary
This paper investigates the validity of the forward exchange rate unbiasedness hypothesis (FRUH) which is indicative of efficiency in the foreign exchange market using more powerful unit root and no unit root tests. The study employs the single break unit root and cointegration analysis to determine whether a stable long-run relationship between the USD/EUR spot and forward exchange rates exits, and generates an error correction model to examine further the dynamics of market efficiency. A brief discussion of the relevant literature and a conceptual framework of analyses are presented. The nature of the data and variables is discussed. The third section presents and analyzes the results, while the last section summarizes the main findings in the paper
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