Anda di halaman 1dari 32

An Empirical Examination of the Post Keynesian View of Forward Exchange Rates

Imad A. Moosa
Department of Economics and Finance
La Trobe University
Victoria 3086
Australia
E-mail: i.moosa@latrobe.edu.au

Abstract
This paper examines the Post Keynesian proposition that the forward rate is determined
by covered interest parity and that it is not a predictor of the future spot rate as suggested
by the unbiased effeiciency hypothesis. One implication of the failure of unbiased
effeciency is that it leads to the faliure of real interest parity, implying that the monetary
authorities can control interest rates in an open economy. An extensive set of econometric
tests is used to demonstrate that the spot-forward relationship is indeed contemporaneous
rather than lagged, which corroborates the Post Keynesian view.

2
Introduction
One of the issues on which there is a rift between neoclassical and Post Keynesian
economists is the ability of the monetary authorities to control interest rates in an open
economy. The neoclassical or mainstream view is that it is impossible to control or
determine the level of interest rates, given the effect of openness and capital flows in the
era of globalisation. In other words, the monetary authorities cannot set real interest
rates that are different from those ruling the rest of the world (Lavoie, 2000, p 168). By
contrast, the Post Keynesian view, as put forward by Lavoie (2000, p 163), is that even
in an open economy with financial mobility, central banks retain the ability to set interest
rates of their choice, within a wide spectrum.

The mainstream neoclassical view is based on the real interest parity (RIP) condition,
stipulating that real interest rates must be equated across countries. As Smithin (2002, p
224) puts it, RIP implies that there is no possibility for any independent control over the
real rate of interest for any individual jurisdiction. Hence, according to Smithin,
interest rates in the small open economy must conform to interest rates established in
world markets or possibly by the world central bank. If the real interest rate is
determined in the world economy, exogenously according to RIP, the nominal interest
rate can only be influenced by controlling the inflation rate. If the inflation rate is beyond
the control of the monetary authorities, then the nominal interest rate cannot be
influenced, since it will be determined as the difference between the exogenous real
interest rate and the domestic inflation rate (which is also determined exogenously by the
world money supply, according to the monetarist theory of inflation). The question that
3
arises here concerns the empirical validity of RIP, for if RIP is not valid then this pillar of
the mainstream argument collapses.

RIP is the most stringent of the four international parity conditions, which also include
covered interest parity (CIP), uncovered interest parity (UIP) and purchasing power
parity (PPP).
1
It is more stringent because the other three conditions need to be satisfied
for RIP to be satisfied. The empirical evidence shows significant deviations from PPP
and UIP but not from CIP. Let us for the purpose of this paper concentrate on UIP, which
is obtained by combining CIP and unbiased efficiency. This means that the empirical
validity of UIP, and hence RIP, requires the empirical validity of the unbiased efficiency
hypotheses stipulating that the forward rate is an unbiased and efficient predictor of the
spot rate prevailing in the future (on the maturity of the underlying forward contract). The
Post Keynesian view, as put forward by Lavoie (2000), is that the forward rate is not a
good predictor of the spot rate. If this view is sound then RIP is not empirically valid,
which casts doubt on the mainstream proposition that the monetary authorities cannot
control interest rates.

The objective of this paper is to demonstrate that the unbiased efficiency hypothesis does
not hold. It is argued that unbiased efficiency is not substantiated by theoretical
plausibility nor is it supported by empirical evidence. It will be specifically shown that
the spot and forward exchange rates are related by a contemporaneous relationship (CIP)

1
For a comprehensive treatment of the parity conditions, see Moosa and Bhatti (1997).

4
rather than a lagged relationship (unbiased efficiency), which necessarily means that the
forward rate cannot be used to forecast the spot rate on an ex ante basis.

The Model
The real interest rate differential can be written as follows:
) ( ) (
*
1
*
1
*
+ +
=
t t t t t t
i i r r (1)
where r is the real interest rate, i is the nominal interest rate, is the subsequent inflation
rate and an asterisk denotes the corresponding foreign (as opposed to domestic) variable.
Obviously, RIP will be violated if 0
*

t t
r r . The right hand side of equation (1) can be
manipulated by adding and subtracting the percentage change in the exchange rate,
1 +

t
s ,
and rearranging to obtain
) ( ) (
1 1
*
1 1
* *
+ + + +
+ + =
t t t t t t t t
s s i i r r (2)
which shows that deviations from RIP (as represented by the real interest differential) is
equal the deviations from UIP (represented by the uncovered interest differential) and
deviations from PPP. Equation (2) can be modified further by adding and subtracting the
forward spread, f, and rearranging to obtain
) ( ) ( ) (
1 1
*
1 1
* *
+ + + +
+ + + =
t t t t t t t t t t
s s f f i i r r (3)
in which case deviations from UIP are split into deviations from CIP (covered interest
differential) and unbiased efficiency (the forward rate forecasting error). If there are no
deviations from CIP and unbiased efficiency then we have
*
t t t
i i f = (4)
1 +
=
t t
s f (5)
5
which are CIP and unbiased efficiency respectively (written in percentage terms). Since
there is no empirical evidence supporting the hypothesis that the exchange rate moves by
a rate that is equal to (or even related to) the interest rate differential, equations (4) and
(5) cannot be mutually consistent, and one of them must be invalid. Our task here to find
out which of these two relationships is invalid. Before we take this matter further, we will
rewrite equations (4) and (5) in levels using exact formulas as follows

+
+
=
*
1
1
t
t
t t
i
i
S F (6)
1 +
=
t t
S F (7)
where S and F are the spot and forward exchange rates respectively. For the purpose of
empirical testing we need to write equations (6) and (7) in stochastic forms as
t t t
v F S + + = (8)
t t t
u F S + + =
1
(9)
where 0 = , ) 1 /( ) 1 (
*
t t
i i + + = , 0 = and 1 = . Note that is a measure of the
interest rate differential, such that 1 = if
*
t t
i i = .
2
Equation (8) is a legitimate
modification of equation (6) once we take into account transaction costs and
measurement errors. While equation (8), which represents CIP, tells us that the
relationship between the spot and forward exchange rates is contemporaneous, equation
(9), which represents unbiased efficiency, tells us that it is lagged.


2
Equations (8) and (9) can be alternatively written as the stochastic versions of (4) and (5), which would
give ) (
*
t t t
i i f + = and
1 +
+ =
t t
s f respectively. The empirical work can be done on the basis of
these specifications if there is concern about nonstationarity and unit roots, but this is not a problem with
the estimation procedure used in this paper. Either way, the results will not be affected qualitatively.
6
The Post Keynesian or cambist view on this issue can be found in Smithin (1994) based
on the argument of Coulobis and Prissert (1974). The argument is that while CIP holds
always perfectly by definition, the forward exchange rate is not an expectation variable
but rather the result of a simple arithmetic operation (Lavoie, 2000, p 172). Therefore,
equation (8) should fit very well with the coefficient restrictions satisfied, because it
represents the simple arithmetic operation. Conversely, equation (9) would produce
poor results, including the violation of coefficient restrictions because it represents a
hypothesis that lacks theoretical plausibility. Smithin (2002, p 220) explains the Post
Keynesian view with reference to equation (9) by suggesting that Post Keynesian
authors presumably do not want to suggest that the discrepancy between the forward
exchange rate and the expected future spot rate is tightly determined by any kind of
statistical/probabilistic process. Moreover, Smithin argues that the failure of unbiased
efficiency can be explained in theoretical terms.

The prime objective of this paper is to find out which of these two relationships is
empirically valid, as judged by the goodness of fit and diagnostics of the estimated
models. But before we proceed to empirical testing we will discuss the theoretical
foundations of CIP and unbiased efficiency, hence following Smithins argument that
some theoretical explanation can be suggested for the failure of unbiased efficiency.

Some Theoretical Considerations: Unbiased Efficiency
The rationale for the unbiased efficiency hypothesis, postulating that the forward rate is
an unbiased and efficient forecaster of the spot rate, can be illustrated as follows. If a
7
speculator believes that the one-period forward exchange rate will be lower than the spot
rate prevailing at time t+1, it will be profitable to buy (the foreign currency) forward and
sell spot when the forward contract matures at t+1. Let
1 + t
S be the spot rate prevailing at
time t+1 where t is the present time, and
t
F be the forward rate agreed upon at time t for
delivery at time t+1. If the speculator is correct, he or she will make profit, m, amounting
to the difference between the selling rate and the buying rate. Hence

t t t
F S m =
+ + 1 1
(10)
If this speculator acts on the basis of public information, then there is no reason why
other speculators do not do the same thing to obtain the same profit as the first speculator
(hence, the assumption of rational expectations). If this happens, the resulting increase in
the demand for forward contracts will raise the forward rate and reduce profit until the
latter disappears. At time t, when the decision to speculate is taken,
1 + t
S is not known,
which means that the speculator has to act on the basis of his or her expectation with
respect to the spot exchange rate. Hence, the speculator buys forward at time t and sells
spot at time t+1 if the expected value of the spot exchange rate is higher than the forward
rate, that is if
t t t
F S E >
+
) (
1
, where E is the expectation operator. Speculation comes to
an end when

t t t
F S E =
+
) (
1
(11)
or if profit is expected to be zero, that is
0 ) (
1
=
+ t t
m E (12)
The term representing speculative profit,
1 + t
m , is also the forecasting error when the
forward exchange rate is used as a forecaster of the spot rate. Thus, the idea is that
8
changes in the forces of supply and demand resulting from the activity of speculators
keep the forecasting error (speculative profit) at zero, making the forward rate (on
average) equal to the spot rate prevailing on the maturity date of the forward contract.

On the surface, this line of reasoning sounds fine, but the problem is that the empirical
evidence for the unbiased efficiency hypothesis is rather weak (see, for example, Lewis,
1995; Engel, 1996; Wang and Jones, 2002; Zhu, 2002). In general, it is agreed now that
unbiased efficiency does not hold, and this failure is typically attributed to the presence
of a (time-varying) risk premium and/or the irrationality of expectations. The presence of
the risk premium is represented by the violation of the restriction 0 = in equation (9),
which will be tested later. For the time being, we will discuss the other pillar of unbiased
efficiency, that of rational expectations.

It has been conclusively established that the idea of rational expectations in the foreign
exchange market is bizarre, to say the least. To start with, the rational expectations
hypothesis precludes heterogeneity in favour of some representative agent hypothesis.
But the literature disputes the validity of this hypothesis, rejecting it in favour of
heterogeneity on the grounds that the former is inconsistent with observed trading
behaviour and the existence of speculative markets. Indeed, it is arguable that there is no
incentive to trade if all market participants are identical with respect to information,
endowments and trading strategies (Frechette and Weaver, 2001). Brock and Hommes
(1997), Cartapanis (1996), and Dufey and Kazemi (1991) have demonstrated that
persistence of heterogeneity can result in boom and bust behaviour under incomplete
9
information. Furthermore, Harrison and Kreps (1978), Varian (1985), De Long et al.
(1990), Harris and Raviv (1993), and Wang (1998) have shown that heterogeneity can
lead to market behaviour that is similar to what is observed empirically.

In response to concerns about the representative agent hypothesis, financial economists
started to model the behaviour of traders in speculative markets in terms of heterogeneity.
Chavas (1999) views market participants to fall in three categories in terms of how they
form expectations: nave, quasi-rational and rational. Weaver and Zhang (1999) allowed
for a continuum of heterogeneity in expectations and explained the implications of the
extent of heterogeneity for price level and volatility in speculative markets. Frechette and
Weaver (2001) classify market participants by the direction of bias in their expectations,
their bullish or bearish sentiment, rather than by how they form expectations. The
message that comes out of this research is loud and clear: homogeneity is conducive to
the emergence of one-sided markets, whereas heterogeneity is more consistent with
behaviour in speculative markets characterised by active trading and volatility.

There is indeed little evidence for rational expectations in the foreign exchange market,
which is the conclusion of studies based on both survey data and the demand for money
approach. For example, Ito (1990) argues that to the extent that individuals are not likely
to possess private information, the presence of individual effects may reflect the failure of
the rational expectations hypothesis. Davidson (1982) argues against the rational
expectations hypothesis by asserting that it is a poor guide to real world economic
behaviour because it assumes that market participants passively forecast events rather
10
than cause them. Both Harvey (1999) and Moosa (1999) find no evidence for rational
expectations in the foreign exchange market based on survey data and estimates of the
demand for money function respectively. Moosa (2002) finds strong empirical support
for the Post Keynesian hypothesis on expectation formation in the foreign exchange
market, hence rejecting rational expectations.

Some Theoretical Considerations: Covered Interest Parity
Apart from the presence of the risk premium and the irrationality of expectations some
other explanations have been put forward for the failure of the unbiased efficiency
hypothesis. These explanations include covered interest parity, the peso problem, central
bank intervention, transaction costs, political risk, foreign exchange risk, purchasing
power risk, interest rate risk, differences in real interest and exchange rates, and the effect
of news (see Moosa, 2000, for details). Out of these, the least emphasised but the most
plausible explanation is that of covered interest parity, which reflects the Post Keynesian
view. This is because this condition implies that the spot and forward rates are related
contemporaneously, which necessarily means that the lagged model represented by
equation (9) is misspecified.
3


The Post Keynesian view stipulates that the forward rate is determined by the CIP
(deterministic) equation (6), which Lavoie calls an arithmetic operation. This equation
can be derived either as an arbitrage condition or a hedging condition. Lavoie (2000, 175)

3
The idea here is that the forward rate (and hence the forward spread) does not reflect exchange rate
expectations but rather the interest rate differential. It is this inconsistency between CIP and unbiasedness
that can be used to explain the failure of unbiased efficiency.
11
seems to suggest that it is more appropriately derived and defined as a hedging condition.
This is at least my interpretation of the following quotations:

An obvious implication of the cambist view of forward exchange market is that
covered interest arbitrage has no impact whatsoever on flows of funds or foreign
reserves.. When covered arbitrageurs decide to sell spot and buy forward
(domestic currency), commercial banks take the buy forward order of their
customers and are the counterpart to it . To cover themselves, banks buy
domestic currency on the spot market. (Lavoie, 2000, p 175).

The forward exchange rate is set by bank dealers at a rate that will allow banks to
cover their costs, and the markup is given by the interest cost differential.
(Lavoie, 2000, p 174).


However, it can be demonstrated that the deterministic CIP equation (6) can be derived
either as an arbitrage or a hedging condition. In the presence of bid-offer spreads,
however, the hedging condition is more plausible, which supports Lavoies view. We will
now illustrate this proposition by deriving CIP as an arbitrage and a hedging condition,
starting with the case of no bid-offer spreads.

Consider covered arbitrage by going short on the domestic currency and long on the
foreign currency while covering the long position forward. By borrowing (one unit of)
the domestic currency at the domestic interest rate, i, converting the borrowed funds at
the current spot rate, S, and investing the funds at the foreign interest rate,
*
i , the
arbitrager obtains ) 1 )( / 1 (
*
i S + units of the foreign currency. The domestic currency
value of the proceeds when they are converted at the forward rate is ) 1 )( / (
*
i S F + . Hence
arbitrage profit is
12
) 1 ( ) 1 (
*
i i
S
F
m + + = (13)
CIP is the no-arbitrage condition obtained when 0 = m , which gives
) 1 ( ) 1 (
*
i i
S
F
+ = + (14)
It is obvious that by manipulating equation (14) we obtain equation (6). The same result
is obtained by conducting arbitrage in the opposite direction (see Moosa, 2003a, 2003b).

Now, we derive equation (6) as a hedging condition. Consider a bank that grants a
customer a forward contract whereby the bank would provide K units of the foreign
currency some time in the future. To cover its short (forward) position on the foreign
currency, the bank borrows an amount equal to ) 1 /(
*
i KS + domestic currency units. This
amount is converted into the foreign currency at the spot exchange rate, which in turn is
invested at
*
i to obtain K units of the foreign currency on maturity. When the domestic
currency loan becomes due, the bank has to pay ) 1 /( ) 1 (
*
i i KS + + . Thus, the implicit
forward rate is given by

+
+
=
+ +
=
*
*
1
1 ) 1 /( ) 1 (
i
i
S
K
i i KS
F (15)
which again gives the CIP equation (6). The same result is obtained when we consider a
bank granting a forward contract to buy the foreign currency (see Moosa, 2003a, 2003b).

When the bid-offer spreads in interest and exchange rates are allowed for, the arbitrage
condition seems to break down, whereas the hedging condition still works. Consider
arbitrage first, repeating the same operation described earlier. In this case the domestic
13
currency value of the proceeds is ) 1 )( / (
*
b a b
i S F + , where the subscripts a and b denote
the offer and bid rates respectively. Thus, arbitrage profit would be
) 1 ( ) 1 (
*
a b
a
b
i i
S
F
m + + = (16)
The problem here is that the no-arbitrate condition can no longer defined as 0 = m , but
rather as 0 > m , in which case the equivalent of equation (6) cannot be derived. It is easy
to demonstrate that if we work on the assumption 0 = m , we obtain the bizarre result that
a b
F F > (Moosa 2003b).

This problem does not arise when we derive the equivalent of equation (6) as a hedging
condition. In this case the value of the domestic currency loan is ) 1 /( ) 1 (
*
b a a
i i KS + + ,
which gives

+
+
=
*
1
1
b
a
a a
i
i
S F (17)
Likewise, it can be shown that

+
+
=
*
1
1
a
b
b b
i
i
S F (18)
in which case
b a
F F > . This proves Lovies view that the CIP condition is more
appropriately defined as a hedging rather than an arbitrage condition. Furthermore,
viewing CIP as a hedging condition may be more appropriate than viewing it as an
arbitrage relationship because the latter requires perfect capital mobility, whereas the
former does not need this requirement. CIP, it is suggested, holds at all times, regardless
14
of the efficiency of capital markets, and whether or not there is perfect capital mobility
(Lavoie, 2002, p 238).

Irrespective of how it is derived, the CIP equation whereby the forward rate is determined
tells us that the spot- forward relationship is contemporaneous, not lagged as the unbiased
efficiency hypothesis suggests. Now, we turn to the empirical results to show that the
lagged relationship is misspecified.

Data and Empirical Results
The empirical results presented in this study are based on quarterly data covering the
period 1980:1-2000:4 on six exchange rates involving the following currencies: U.S.
dollar (USD), Canadian dollar (CAD), Japanese yen (JPY), and British pound (GBP).
The data were obtained from the OECDs Main Economic Indicators. We start with some
informal examination of the behaviour of spot and exchange rates.

Figure 1 shows the relationship between the spot and (lagged) forward exchange rates
involving the four currencies. The observed behaviour of the two rates obviously
supports the contemporaneous rather than the lagged relationship. We can see that the
lagged forward rate reverses direction after the spot rate, which means that the former is a
follower, not a predictor, of the latter. This behaviour shows that the two rates are
determined jointly and that they are related by a contemporaneous relationship, which is
CIP. Given the behaviour exhibited by the spot and forward rates, the forward rate must
be a very bad forecaster berceuse it consistently misses the turning points in the spot rate.
15
In fact, the forward rate fails to predict turning points consistently, and this is why we
have errors of directions ranging between 59 per cent of total observations in the case of
the JPY/USD rate and 33.7 per cent in the case of the GBP/USD rate. In practical
financial decision making (such as hedging and speculation) forecasting the direction of
change may be more important than forecasting the magnitude of change. By definition,
if the spot and forward rates are contemporaneously related, then the forward rate cannot
be used to forecast the spot rate on an ex ante basis, which is what matters in practice.

Now, we present the results of estimating CIP and the unbiased efficiency model as
represented by equations (8) and (9). In order to allow for time variation in the
coefficients over time, the two equations are written in a TVP framework as follows:
t t t t t
v F S + + = (19)
t t t t t
u F S + + =
1
(20)
The terms
t
and
t
represent (time-varying) stochastic trends, which may represent the
variables not appearing explicitly on the right hand side of the equations (missing
variables, if any). According to the deterministic versions of these equations, there are no
missing variables. In equation (20), however,
t
may be taken to represent a time-
varying risk premium. These trends are specified in such a way as to allow for
possibilities ranging from I(0) to I(2) variables, without having to worry about unit root
testing, as the data will speak for itself.
4
The estimation method is maximum likelihood

4
With respect to equation (19), for example,
t
is specified as
t t t t
+ + =
1 1
, where
t t t
+ =
1
,
) , 0 ( ~
2

NID
t
and ) , 0 ( ~
2

NID
t
. Whether the underlying time series is I(0), I(1) or I(2) depends on
16
coupled with the recursive routine of the Kalman filter. This requires writing the two
equations in state space form (see, for example, Cuthbertson et al, 1992; Harvey, 1989;
Koopman et al, 1995).

The results of estimating equations (19) and (20) in a TVP framework are presented in
Table 1, which reports the estimated coefficients of the final state vector (with the t
statistics in parentheses) as well as some diagnostics and goodness of fit measures. Q is
the Ljung-Box test statistic for serial correlation, which is distributed as ) 8 (
2
. H is a test
statistic for heteroscedasticity, distributed as F(27,27). The AIC and BIC are respectively
Akaikes Information Criterion and the Schawrtz Bayesian Information Criterion.

The results tell us that equation (19), which represents CIP, fits very well and passes the
diagnostic tests for serial correlation and heteroscedasticity in all cases. The coefficients
have the anticipated values, as 0 =
t
and 0 >
t
. In contrast, equation (20), which
represents unbiased efficiency, fails to pass the diagnostic test for serial correlation in two
cases, and it is inferior to equation (19) in terms of the BIC and AIC. More importantly,
the coefficient restrictions 0 =
t
and 1 =
t
are rejected consistently. Moreover, the
restriction 0 =
t
cannot be rejected in four out of six cases, implying no connection
between the spot and lagged forward rates. The rejection of the restriction 0 =
t
is
interpreted in the literature to indicate the presence of a risk premium, to which the
failure of unbiased efficiency is attributed. In fact this result is taken to be a salvation for

the variances
2

and
2

. Since exchange rates typically follow a random walk with little or no drift, it is
likely the case that 0 =
t
.
17
the unbiased efficiency hypothesis as the argument goes as follows: if the risk premium is
allowed for then the forward rate, with the help of the risk premium, can predict the
future spot rate rather well. Hence, we move from the so-called simple efficiency to the
so-called general efficiency. Furthermore, Smithin (2002) believes in the existence of
this term, although he argues that whether it is called a risk premium seems to be
primarily a terminological issue. For example, he suggests that this term may be a
negative function of the real net foreign credit position.

However, it is not difficult to expose this myth of the risk premium and general
efficiency. It can be shown that, in the presence of a contemporaneous relationship
between the spot and forward rates, the effect of the alleged risk premium disappears.
This can be done by estimating the following equation
t t t t t t t
v F F S + + + =
1
(21)
The results of estimating equation (21) are presented in Table 2. The equation fits well
and passes the diagnostics for serial correlation and heteroecedasticity. What is more
important about these results is the significance of the estimated coefficients. We can see
that once the effect of the contemporaneous forward rate is allowed for, the coefficient
representing the risk premium is no longer significant. This shows that this coefficient
does not represent a risk premium as such but it rather represents the missing
contemporaneous rate in equation (20). Thus the term
t
in equation (19) is
representative of transaction costs as well as the effect of other factors that cause
18
deviations from CIP, and hence it may or may not be statistically significant.
5
It is
important to point out at this juncture that this result is not inconsistent with Smithins
(2002) argument about
t
. The presence of this term is theoretically plausible on the
grounds suggested by Smithin or what is suggested in this paper. However, the
importance of this term is a purely empirical matter. It remains the case here that the
results tell us that the relationship is indeed contemporaneous rather than lagged.

Further Empirical Results
In this section further results are presented to demonstrate that the relationship between
the spot and forward rates is contemporaneous rather than lagged. The results are
obtained from non- nested model selection tests and measures of forecasting accuracy. For
the purpose of conducting non- nested model selection tests, let
1
M be the
contemporaneous model and
2
M the lagged model. These two models are non- nested in
the sense that the explanatory variables of one model are not linear combinations of the
explanatory variables of the other. By applying non-nested model selection tests, we can
tell whether or not
1
M is preferred to
2
M , and hence whether
t
F or
1 t
F is the
appropriate explanatory variable. For this purpose, six model selection tests are used: N is
the Cox (1961, 1962) test as formulated in Pesaran (1974); NT is the adjusted Cox test
formulated by Godfrey and Pesaran (1983); W is the Wald-type test proposed by Godfrey
and Pesaran (1983); J is the Davidson-MacKinnon (1981) test; JA is the Fisher-McAleer

5
Apart from transaction costs, these factors include political risk, tax differentials, liquidity differences,
capital controls, capital market imperfections and speculation. Moosa (2003b) presents a model showing
how speculation could lead to deviations from CIP and hence the significance of
t
. This model is based
on a similar argument to that presented by Lavoie (2002) on the role of speculation in the forward market.

19
(1981) test; and EN is the encompassing test proposed, inter alia, by Mizon and Richard
(1986). All of the test statistics have t distribution except the EN test, which has an F
distribution with (1,104) degrees of freedom. In testing
1
M against
2
M , a significant test
statistic implies the rejection of
1
M in favour of
2
M and vice versa. The results, which
are presented in Table 3, show that all tests lead to consistent results:
1
M cannot be
rejected against
2
M , but
2
M is always rejected against
1
M . Hence,
1
M is the preferred
model, implying the superiority of the contemporaneous relationship.

Now, we compare the (ex post out-of-sample) forecasting power of the lagged and
contemporaneous models represented by equations (19) and (20) respectively. The
purpose of this exercise is to demonstrate that the contemporaneous model is more
powerful in forecasting the spot exchange rate out of sample, hence enhancing the results
showing that the lagged model is not correctly specified.

For this purpose the two models are estimated over the period up to 1996:4, then the
estimated models are used to forecast the spot exchange rate over the period 1997:1-
2000:4. Table 4 reports the mean square error (MSE) and the root mean square error
(RMSE) of the contemporaneous and lagged models. The results show that the
contemporaneous model has a lower MSE and RMSE than the lagged model. This is also
shown in Figure 2, which plots the forecasting errors of the two models

To find out if the difference in the forecasting power of the two models is statistically
significant, we use the Ashley, Granger and Schmalensee (1980) AGS test for the
20
difference of the RMSEs of two models. The AGS test requires the estimation of the
linear regression

t t t
u X X D + + = ) (
1 0
(22)
where
t t t
w w D
2 1
= ,
t t t
w w X
2 1
+ = , X is the mean of X,
t
w
1
is the out-of-sample error
at time t of the model with the higher RMSE (the lagged model) and
t
w
2
is the out-of-
sample error at time t of the model with the lower RMSE (the contemporaneous model).
If the sample mean of the forecast errors is negative, the forecast error series must be
multiplied by 1 before running the regression.

The estimates of the intercept term (
0
) and the slope (
1
) are used to test the statistical
difference between the RMSEs of the contemporaneous and lagged models. If the
estimates of
0
and
1
are both positive, then a Wald test of the joint hypothesis
0 :
1 0 0
= = H is appropriate. However, if one of the estimates is negative and
statistically significant then the test is inconclusive. But if the estimate is negative and
statistically insignificant the test remains conclusive, in which case significance is
determined by the upper-tail of the t-test on the positive coefficient estimate.

The results of the AGS test are presented in Table 5. Since all of the coefficients are
positive a Wald test for the joint coefficient restriction 0
1 0
= = is used. It is obvious
that the null hypothesis (that the RMSE of the contemporaneous model is not
significantly different from that of the lagged model) is decisively rejected in all cases.
Thus, we can firmly state the conclusion that the contemporaneous model is superior to
21
the lagged model, which is inferior because it is misspecified.

It is noteworthy that, by its very nature, the contemporaneous model cannot be used for
ex ante forecasting. Hence, the forward rate cannot be used as a forecaster of the spot
rate. Indeed if one suggests that the forward rate can be used as a forecaster of the spot
rate, one can also argue that the spot rate is a forecaster of the forward rate. The validity
of the contemporaneous model tells us that the two rates are determined jointly by other
(the same) factors, and so they can only be predicted jointly.

Conclusions
The results presented in this paper, on the basis of an extensive set of empirical tests,
explain what Ethier (1988, p 516) calls the neoclassical puzzle that day-to-day
movements in forward rates tend to be accompanied by almost identical day-to-day
movements in current (not future) spot rates. The explanation, which is supported by the
empirical results presented here, is that the spot-forward relationship is contemporaneous,
as represented by covered interest parity, rather than lagged, as represented by the
unbiased efficiency hypothesis. It was demonstrated explicitly and comprehensively that
the forward rate cannot be used to forecast the spot rate because the two rates are
determined jointly and contemporaneously. The failure of unbiased efficiency can be
rationalised theoretically on several grounds, most notably the failure of the ill- fated
rational expectations hypothesis. While the initial empirical results show that the failure
of unbiased effect can be attributed to the presence of the risk premium, or whatever it
may be called, other results show that what appears to be a risk premium is a stochastic
trend reflecting missing variables or, in the case of a correctly specified model, such
22
factors as transaction costs. As far as CIP is concerned, this paper puts forward the
argument that this condition is more appropriately perceived and derived as a hedging
rather than an arbitrage condition, which is consistent with the argument put forward by
Lavoie (2000). However, what is important for the main objective of this paper is not
how CIP is derived but rather that it represents the correct specification of the spot-
forward relationship.

The finding that the spot rate is related to the contemporaneous rather than the lagged
forward rate implies the failure of the unbiased efficiency hypothesis. Given that this is a
necessary condition for RIP to hold, this finding implies the empirical failure of RIP,
irrespective of the validity of PPP (which is another necessary condition). If this is the
case then the Post Keynesian view that the monetary authorities can control domestic
interest rates is valid, or at least that the opposite mainstream view is invalid.
23
References
Ashley, R., Granger, C.W.J. and Schmalensee, R. (1980) Advertising and Aggregate
Consumption: An Analysis of Causality, Econometrica, 48, 1149-1167.
Brock, W.A. and Hommes, C.H. (1997) A Rational Route to Randomness, Econometrica,
65, 1059-1095.
Cartapanis, A. (1996) LHeterogeneite des Anticipations dans les Modeles de Change,
Economie Appliquee, 49, 173-205.
Chavas, J.P. (1999) On the Economic Rationality of Market Participants : The Case of
Expectations in the U.S. Pork Market, Journal of Agricultural and Resource
Economics, 24, 19-37.
Coulbois, P. and Prissert, P. (1974) Short Term Capital Flows and Monetary Policy, De
Economist, 122, 283-308.
Cox, D.R. (1961) Tests of Separate Families of Hypotheses, in Proceedings of the Fourth
Berkeley Symposium on Mathematical Statistics and Probabilit y, Vol 1, Berkeley:
University of California Press.
Cox, D.R. (1962) Further Results on Tests of Separate Families of Hypotheses, Journal
of the Royal Statistical Society, Series B, 24, 406-424.
Cuthbertson, K., Hall, S.G. and Taylor, M.P. (1992) Applied Econometric Techniques,
Hemel Hempstead: Phillip Allan.
Davidson, P. (1982) Rational Expectations: A Fallacious Foundation for Studying Crucial
Decision Making Processes, Journal of Post Keynesian Economics, 5, 182-198.
Davidson, R. and MacKinnon, J.G. (1981) Several Tests for Model Specification in the
Presence of Alternative Hypothesis, Econometrica, 49, 781-193.
24
De Long, J.B., Shleifer, A., Summers, L.H. and Waldman, R.J. (1990) Noise Trader Risk
in Financial Markets, Journal of Political Economy, 98, 703-738.
Dufey, G. and Kazemi, H.B. (1991) Demand and Supply of Forward Exchange Contracts
Under Incomplete Information, Journal of Economics and Business, 43, 339-352.
Engel, C. (1996) The Forward Discount Anomaly and Risk Premium: A Survey of
Recent Evidence, Journal of Empirical Finance, 3, 123-191.
Ethier, W.J. (1988) Modern International Economics, New York: W.W. Norton.
Fisher, G.R. and McAleer, M. (1981) Alternative Procedures and Associated Tests of
Significance for Non-Nested Hypotheses, Journal of Econometrics, 16, 103-119.
Frechette, D.L. and Weaver, R.D. (2001) Heterogenous Expectations of Traders in
Speculative Futures Markets, Journal of Futures Markets, 21, 429-446.
Godfrey, L.G. and Pesaran, M.H. (1983) Test of Non-Nested Regression Models: Small
Sample Adjustments and Monte Carlo Evidence, Journal of Econometrics, 21,
133-154.
Harris, M. and Raviv, A. (1993) Differences of Opinion Makes a Horse Race, Review of
Financial Studies, 6, 473-506.
Harrison, J.M. and Kreps, D.M. (1978) Speculative Investor Behavior in a Stock Market
with Heterogeneous Expectations, Quarterly Journal of Economics, 93, 323-336.
Harvey, A.C. (1989) Forecasting: Structural Time Series Models and the Kalman Filter,
Cambridge: Cambridge University Press.
Harvey, J.T. (1999) The Nature of Expectations in the Foreign Exchange Market: A Test
of Competing Theories, Journal of Post Keynesian Economics, 21, 181-200.
25
Ito, T. (1990) Foreign Exchange Rate Expectations: Micro Survey Data, American
Economic Review, 80, 434-49.
Koopman, S.J, Harvey, A.C., Doornik, J.A. and Shephard, N. (1995) STAMP 5.0:
Structural Time Series Analyser, Modeller and Predictor, London: Chapman and
Hall.
Lavoie, M. (2000) A Post Keynesian View of Interest Parity Theorems, Journal of Post
Keynesian Economics, 23, 163-179.
Lavoie, M. (2002) Interest parity, Risk Premia and Post Keynesian Analysis, Journal of
Post Keynesian Economics, 25, 237-249.
Lewis, K.K. (1995) Puzzles in International Financial Markets. In Grossman and Rogoff
(eds) Handbook of International Economics, vol 3, Amsterdam: North-Holland.
Meese, R.A. and Rogoff, K. (1983) Empirical Exchange Rate Models of the Seventies:
Do They Fit out of Sample? Journal of International Economics, 14, 3-24.
Mizon, G.E. and Richard, J.F. (1986) The Encompassing Principle and its Application to
Non-Nested Hypotheses, Econometrica, 54, 657-678.
Moosa, I.A. (1999) Testing the Currency-Substitution Model under the German
Hyperinflation, Journal of Economics, 70, 61-78.
Moosa, I.A. (2000) Exchange Rate Forecasting: Techniques and Applications, London:
Macmillan.
Moosa, I.A. (2002) A Test of the Post Keynesian Hypothesis on Expectation Formation
in the Foreign Exchange Market, Journal of Post Keynesian Economics, 24, 443-
457.
26
Moosa, I.A. (2003a) International Finance: An Analytical Approach (second edition),
Sydney: McGraw Hill.
Moosa, I.A. (2003b) International Financial Operations: Arbitrage, Hedging,
Speculation, Financing and Investment, London: Palgrave.
Moosa, I.A. and Bhatti, R.H. (1997) International Parity Conditions: Theory,
Econometric Testing and Empirical Evidence, London: Macmillan.
Pesaran, M.H. (1974) On the General Problem of Model Selection, Review of Economic
Studies, 41, 153-171.
Smithin, J. (1994) Controversies in Monetary Economics: Ideas, Issues and Policy,
Cheltenham, Edward Elgar.
Smithin, J. (2002) Intertest Parity, Purchasing Power Parity, Risk Premia, and Post
Keynesian Economic Analysis, Journal of Post Keynesian Economics, 25, 219-
235.
Varian, H.R. (1985) Divergence of Opinion in Complete Markets, Journal of Finance,
40, 309-317.
Wang, F.A. (1998) Strategic Trading, Asymmetric Information and Heterogeneous Prior
Beliefs, Journal of Financial Markets, 1, 321-352.
Wang, P. and Jones, T. (2002) Testing for Efficiency and Rationality in Foreign
Exchange Markets- A Review of the Literature and Research on Foreign
Exchange Market Efficiency and Rationality with Comments, Journal of
International Money and Finance, 21, 223-239.
27
Weaver, R.D. and Zhang, Y. (1999) Volatility of Market Prices: The Role of
Heterogeneous Expectations. Paper Presented at the Annual Meetings of the
American Agricultural Economic Association, Nashville, TN.
Wolff, C.C.P. (1987) Time Varying Parameters and the Out of sample Forecasting
Performance of Structural Exchange Rate Models, Journal of Business and
Economic Statistics, 42, 395-406.
Zhu, Z. (2002) Time-Varying Forward Bias and the Expected Excess Return, Journal of
International Financial Markets, Institutions and Money, 12, 119-137.
28
Table 1: Estimation Results (Equations 19 and 20)

CAD/USD GBP/USD JPY/USD CAD/GBP JPY/GBP JPY/CAD
Eq (19)
t

0.027 0.006 1.341 0.040 10.051 1.009
(1.52) (0.87) (1.45) (1.39) (1.14) (1.45)
t

0.982 0.992 1.003 0.981 0.952 1.002
(8.31) (103.48) (122.84) (79.05) (48.12) (110.94)
2
R
0.99 0.99 0.99 0.99 0.99 0.99
DW 1.92 1.83 1.90 1.86 1.87 2.00
Q 4.17 0.04 11.44 6.99 9.07 12.94
H 1.19 0.16 0.01 0.24 0.03 0.06
AIC -11.19 -11.13 -0.48 -8.38 2.23 -0.76
BIC -11.10 -11.09 -0.40 -8.30 2.33 -0.67

Eq (20)
t

1.473 0.554 102.13 1.915 134.91 57.30
(9.02) (7.55) (8.93) (8.12) (8.21) (7.08)
t

0.018 0.171 0.119 0.146 0.233 0.258
(0.17) (1.57) (1.11) (1.37) (2.23) (2.48)
2
R
0.94 0.81 0.96 0.78 0.97 0.96
DW 1.93 1.99 1.99 1.98 1.97 2.05
Q 8.60 18.17 7.87 17.64 4.79 4.43
H 0.98 0.29 0.28 0.51 0.31 0.21
AIC -7.10 -6.76 4.73 -4.25 5.57 4.27
BIC -7.01 -6.68 4.82 -4.17 5.65 4.36

29
Table 2: Estimation Results (Equation 21)
CAD/USD GBP/USD JPY/USD CAD/GBP JPY/GBP JPY/CAD
Eq (19)
t

0.045 -0.001 2.885 -0.001 9.450 1.918
(1.18) (0.15) (1.61) (-0.003) (1.29) (1.23)
t

0.990 0.971 1.006 0.966 0.949 1.004
(70.46) (84.60) (124.9) (73.20) (46.43) (111.7)
t

-0.020 0.030 -0.018 0.033 0.009 -0.015
(-1.43) (1.76) (-1.38) (1.55) (0.43) (-1.76)
2
R
0.99 0.99 0.99 0.99 0.99 0.99
DW 1.86 1.88 1.96 1.61 1.86 2.02
Q 2.26 6.59 11.47 6.53 8.77 11.22
H 1.40 0.16 0.02 0.27 0.03 0.06
AIC -11.18 -11.25 -0.52 -8.44 2.26 -0.77
BIC -11.07 -11.13 -0.40 -8.32 2.38 -0.65

30
Table 3: Non-Nested Model Selection Tests
(M
1
: Contemporaneous, M
2
: Lagged)
CAD/USD GBP/USD JPY/USD CAD/GBP JPY/GBP JPY/CAD
M
1
vs M
2

N 1.04 -1.06 1.84 -1.24 -0.87 1.13
NT 1.04 -1.03 1.80 -1.21 -0.86 1.09
W 1.05 -1.14 1.16 -1.04 -0.84 1.20
J -1.05 1.02 -1.38 1.18 0.84 -1.39
JA -1.05 1.02 -1.38 1.18 0.84 -1.39
EN 1.11 1.12 1.19 1.14 0.70 1.54

M
2
vs M
1

N -43.63 -49.98 -49.61 -42.23 -33.12 -49.43
NT -43.20 -49.46 -49.02 -41.61 -32.81 -48.83
W -10.28 -10.80 -9.32 -10.16 -9.01 -9.27
J 57.92 72.81 100.52 52.12 37.17 96.43
JA 57.92 72.81 100.52 52.12 37.17 96.43
EN 3354.61 5301.30 10104.90 2716.15 1382.0 9299.71

31
Table 4: Indicators of Forecasting Power

CAD/USD GBP/USD JPY/USD CAD/GBP JPY/GBP JPY/CAD
MSE (
3
10 )

Contemporaneous 0.0233 0.0037 14.437 0.0899 78.930 85.921
Lagged 0.816 0.375 69274.7 7.399 170.4 30860.9

RMSE
Contemporaneous 0.005 0.002 0.120 0.009 0.888 0.293
Lagged 0.028 0.019 8.32 0.086 13.054 5.555



32
Table 5: Results of the AGS Test
Coefficient
CAD/USD GBP/USD JPY/USD CAD/GBP JPY/ GBP JPY/CAD
0

0.008 0.005 0.028 0.006 1.338 0.465
(3.25) (4.98) (0.69) (1.12) (4.35) (3.08)
1
1.005 0.958 1.022 0.985 0.901 0.972
(10.44) (18.56) (208.34) (16.79) (39.96) (36.14)
2
( ) 0
1 0
= =
119.6 369.6 42408.0 283.3 1615.8 1315.8