The Term Structure of Forward Exchange Premiums and the Forecastability of Spot Exchange Rates: Correcting the Errors

Abstract

We develop a framework to extract information regarding subsequent spot rate movements from the term structure of forward exchange premiums while admitting possible deviations from rationality and the presence of risk premiums. Using weekly dollar-sterling, dollar-mark, and dollar-yen data, the restrictions implied by our framework are not rejected, and spot and forward exchange rates together are well represented by a vector error correction model (VECM). Dynamic out-of-sample forecasts up to one year ahead indicate that the VECM is strikingly superior to a range of alternative forecasts, including a random walk and standard spot-forward regressions.

JEL Classification: F31