Cointegration and Forward and Spot Exchange Rate Regressions

Abstract

In this paper we investigate in detail the relationship between models of cointegration between the current spot exchange rate, st, and the current forward rate, ft, and models of cointegration between the future spot rate, st+1, and ft and the implications of this relationship for tests of the forward rate unbiasedness hypothesis (FRUH). We argue that simple models of cointegration between st and ft more easily capture the stylized facts of typical exchange rate data than simple models of cointegration between st+1 and ft and so serve as a natural starting point for the analysis of exchange rate behavior. We show that simple models of cointegration between st and ft imply rather complicated models of cointegration between st+1 and ft. As a result, standard methods are often not appropriate for modeling the cointegrated behavior of (st+1, ft)' and we show that the use of such methods can lead to erroneous inferences regarding the FRUH.cointegration, exchange rates, forward rate unbiasedness, weak exogeneity