Forward premiums and market eﬃciency: Panel unit-root evidence from the term structure of forward premiums John Barkoulas a,b, Christopher F. Baum Atreya Chakraborty d a c
Department of Economics, The University of Tennessee, Knoxville, TN 37996, USA b Athens Laboratory of Business Administration, Vouliagmeni, Greece Department of Economics, Boston College, 140 Commonwealth Avenue, Chestnut Hill, MA 02467-3806, USA d The Brattle Group, 44 Brattle Street, Cambridge, MA 02138, USA Received 23 June 2000; accepted 2 October 2001
Abstract A plausible explanation for cointegration among spot currency rates determined in eﬃcient markets is the existence of a stationary, time-varying currency risk premium. Such an interpretation is contingent upon stationarity of the forward premium. However, empirical evidence on the stochastic properties of the forward premium series has been inconclusive. We apply a panel unit-root test – the Johansen likelihood ratio (JLR) test – to forward exchange premiums by utilizing cross-sectional information from their term structure. In contrast to earlier studies, the JLR test provides decisive and temporally stable evidence in support of stationary forward premiums, and therefore foreign exchange market eﬃciency, for six major currencies. Ó 2003 Elsevier Science Inc. All rights reserved. JEL classiﬁcation: F30; F31 Keywords: Forward premium; Currency risk premium; Panel unit-root tests; Foreign exchange market eﬃciency
Corresponding author. Tel.: +1-617-552-3673; fax: +1-617-552-2308. E-mail address: firstname.lastname@example.org (C.F. Baum).
0164-0704/03/$ - see front matter Ó 2003 Elsevier Science Inc. All rights reserved. doi:10.1016/S0164-0704(03)00009-0
J. Barkoulas et al. / Journal of Macroeconomics 25 (2003) 109–122
1. Introduction The weak-form eﬃciency hypothesis of foreign exchange markets presents testable implications for the time series behavior of systems of spot currency rates. 1 ResearchersÕ empirical ﬁndings of cointegration in systems of spot exchange rates (Alexander and Johnson, 1992; Lopez, 1996; Baillie and Bollerslev, 1989, 1994a, inter alia) would seem to contradict the market eﬃciency hypothesis, since a cointegrated system necessarily implies the presence of predictability of returns in at least one currency. 2; 3 Does the existence of cointegration among spot rates imply a rejection of the market eﬃciency hypothesis? 4 Crowder (1994) argues that the cointegrating relationship may merely reﬂect a common feature: a time-varying currency risk premium evident in several currenciesÕ returns. 5 Under conditions of risk aversion, foreign exchange market eﬃciency implies that a time-varying risk premium must share the same stochastic properties with the error-correction term from the cointegrated system, that is, it must be covariance stationary. Since the risk premium is unobservable, its stochastic properties cannot be directly ascertained, but it can be shown that they depend on the order of integration of the forward premium. Therefore, the ﬁnding of a stationary forward premium would directly imply stationarity of the currency risk premium, which would be compatible with the temporal behavior of the error correction term from a cointegrated system of spot exchange rates. Our investigation of the foreign exchange market eﬃciency hypothesis thus proceeds from a study of the stochastic properties of forward premiums. The empirical evidence on the stochastic properties of forward premiums is decidedly mixed. Using daily data for four currencies, Crowder (1992) ﬁnds that forward premium series are nonstationary processes. Crowder (1994) conﬁrms such unit-root evidence for monthly forward premium series for three currencies, and concludes that the data do not support the market eﬃciency hypothesis. Luintel and Paudyal (1998) ﬁnd daily forward premium series for ﬁve currencies to be...