COMMON STOCHASTIC TRENDS BETWEEN FORWARD AND SPOT EXCHANGE-RATES

The common trend analyses between the forward rate (F-t) and the corre sponding future spot rate of the same currency (St+1) have raised seve ral issues: notably, the sensitivity of the cointegrating relation to a constant term and lag lengths and the non-stationarity of the risk p remium. This paper addresses these issues more rigorously using the da ily exchange rate of the pound Sterling vis-a-vis five major currencie s viz. the Canadian dollar, French franc, German mark, Japanese yen, a nd US dollar. The appropriate deterministic term in the cointegrating space is identified through empirical tests. A robust cointegrating re lation is found between F-t and St+1; however, the hypothesis of unbia sedness of forward rate could not be sustained. An alternative measure of risk premium is suggested and its stationarity is confirmed. (C) 1 998 Elsevier Science B.V. All rights reserved.