Spot-Forward Cointegration, Structural Breaks and FX Market Unbiasedness

Abstract

FX market unbiasedness requires spot-forward cointegration with unitary vector, or a stationary forward-premium (FP). These conditions have found mixed support, which recent research explains via FP fractional integration. An alternative explanation is breaks in spot-forward cointegration regressions, so that I apply Gregory and Hansen (1996a, b) models to DM, Yen and Pound data, allowing for intercept, slope, and time-trend shifts. I adapt the procedure of Bai (1997) to sequentially search for multiple breaks, and find evidence of cointegration with regime-and-trend shifts for the three currencies. Cointegration-with-breaks regressions show stationary residuals and unitary slopes across regimes, consistent with long-run unbiasedness overall. Forward-premium regressions estimated for subsamples determined by cointegration-regression break dates find support for short-run unbiasedness in some regimes but not others.

Keywords: forward rates, market unbiasedness, structural breaks

JEL Classification: F31, G15, C52