Role of the Forward Market

Journal of Macroeconomics 25 (2003) 109–122 www.elsevier.com/locate/econbase

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

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.: [phone]; fax: [phone]. E-mail address: [e-mail] (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

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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

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