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Structural change in the forward discount: Implications for the forward rate unbiasedness hypothesis
Authors:Georgios Sakoulis  Eric Zivot  Kyongwook Choi
Institution:1. Grantham, Mayo, Van Otterloo and Company LLC, United States;2. Department of Economics, University of Washington, United States;3. Department of Economics, University of Seoul, Republic of Korea
Abstract:It is a well-accepted empirical result that forward exchange rate unbiasedness is rejected in tests using the “differences regression” of the change in the logarithm of the spot exchange rate on the forward discount. We model the forward discount as an AR(1) process and argue that its persistence is exaggerated due to the presence of structural breaks. We show using a stochastic multiple break model that the forward discount persistence is substantially less if one allows for multiple structural breaks in the mean of the process. We argue that these breaks could be identified as monetary shocks to the central bank's reaction function. Using Monte Carlo simulations, we show that if we do not account for structural breaks that are present in the forward discount process, the forward discount coefficient in the “differences regression” is severely biased downward, away from its true value of 1.
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