ABSTRACT
In this chapter we consider the literature on the efficiency of the forward foreign exchange market. Although the literature relating to this concept is voluminous, in essence it focuses on a very simple relationship between spot and forward exchange rates. More specifically, central to this literature is the concept that the forward exchange rate is the market’s consensus of the expected exchange rate and is an unbiased forecast of the future spot exchange rate. The next section of this chapter considers the basic spot forward relationship and we note that the empirical evidence indicates that the forward rate is in fact a biased predictor of the future spot rate. In Section 15.2 we outline the so-called Fama decomposition, which seeks to explain the biasedness result in terms of time-varying risk premia, and we also consider issues of irrational expectations and small sample biases in the context of this decomposition. In Section 15.3 we return to the general equilibrium model of Chapter 4 and the portfolio-balance model of Chapter 7 in order to examine the role of time-varying risk premia as the key explanation for biasedness. In Section 15.4 expectational reasons for the failure of the biasedness result are discussed in greater detail. Issues relating to the empirical implementation of the hypothesis are considered in Section 15.5 and in Section 15.6 we consider the usefulness of survey data in explaining the forward premium puzzle.
