Nonlinear adjustment in the forward premium: evidence from a threshold unit root test |
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| Institution: | 1. Helmut-Schmidt-University, Department of Economics, Holstenhofweg 85, P.O.B. 700822, 22008 Hamburg, Germany;2. Department of Economics, WHU-Otto Beisheim School of Management, Burgplatz 2, 56179 Vallendar, Germany;1. Department of Applied Economics, National University of Kaohsiung, Kaohsiung 811, Taiwan, ROC;2. Department of Economics, Keio University, Tokyo 108-8345, Japan;1. Economics and Management School, Wuhan University, Wuhan 430072, China;2. Business School, Jianghan University, Wuhan 430056, China;3. College of Economics and Management, Huazhong Agricultural University, Wuhan 430070, China |
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| Abstract: | This paper considers testing the mean reversion of the forward premium in a nonlinear framework. In contrast to previous studies, we consider a novel approach that allows for testing for a unit root in the forward premium while explicitly allowing for nonlinearity in the data. Within this approach, we employ bootstrap methods based on threshold autoregressive (TAR) models to investigate whether the 1- and 3-month forward premia for six industrialized countries are mean-reverting. Overall, we are able to reject the null hypotheses of linearity and nonstationarity indicating nonlinear mean reversion. Furthermore, large deviations of the forward premium from its equilibrium band are found to have faster speed of mean reversion than small deviations, which are strongly persistent. In all, the results support the view that the forward premium exhibits mean reversion, but in a special manner not captured by the usual linear tests. Finally, the results have important implications for foreign exchange market efficiency under risk aversion. |
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