On the Biasedness of Forward Foreign Exchange Rates: Irrationality or Risk Premia?

Abstract

In this article, the authors reconsider the K. A. Froot and J. A. Frankel (1989) results on the sources of forward discount bias. They question the economic validity of some estimation restrictions that they impose and, thus, are led to question some of their results. The authors employ a new exchange rate survey database that includes European Monetary System currencies and use univariate and pooling estimation techniques that impose fewer restrictions than those of Froot and Frankel to test their hypotheses. They find that the bias in the forward discount is attributable to both the failure of rational expectations and the existence of time-varying risk premia. Copyright 1994 by University of Chicago Press.

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