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School of Business | Department of Finance | Finance | 2014
Thesis number: 13810
Unbiased forward rate and time horizon in emerging economies and implications to hedging practices
Author: Varetsalo, Veli-Rasmus
Title: Unbiased forward rate and time horizon in emerging economies and implications to hedging practices
Year: 2014  Language: eng
Department: Department of Finance
Academic subject: Finance
Index terms: rahoitus; financing; valuutta; currency; riskienhallinta; risk management; arvopaperimarkkinat; stock exchange markets
Pages: 75
Full text:
» hse_ethesis_13810.pdf pdf  size:3 MB (2936835)
Key terms: Uncovered interest rate parity; unbiased forward rate hypothesis; time horizon effect; emerging economies; foreign exchange; hedging; OTC forward contract
Abstract:
PURPOSE OF THE STUDY:

The purpose of this study is to test the unbiased forward rate hypothesis in emerging economies and the impact of time horizon. The unbiased forward rate hypothesis tests whether a forward rate is an unbiased predictor of future exchange rate. The implications of findings on hedging foreign exchange risk are intended to be analyzed.

DATA AND METHODOLOGY:

The data consists of monthly observations of exchange rates and forward premiums for the maturities of 1-, 3-, 6- and 12-months for ten emerging economies: Brazil, Chile, Czech Republic, India, Indonesia, Mexico, Russia, South Africa, South Korea and Turkey. The exchange rate data is retrieved from Bloomberg terminal and all the quotes are against US dollar. For the aforementioned maturities, the unbiased forward rate hypothesis is tested with the Fama regression model using Newey-West standard errors. The time horizon effect for maturities of one and five years is examined by a graphical depiction of the forward prediction error in exchange rate terms. The five year forward premium is approximated by a sum of five consequent one year forward premiums.

FINDINGS:

On one month interval, the unbiased forward hypothesis is rejected in the emerging economies. Extending the time horizon to one year, the regression model produces increasingly biased estimates of future exchange rate. The graphical depiction of forward forecast error confirms the findings from the regression model. When comparing the one year bias to five year bias, measured in exchange rate terms, the bias is found to increase along with the extended time horizon. In the majority of the sample countries, on the five year maturity the forward prediction error becomes consistently positive implying that the five year forward rate is a systematically upwards biased predictor of future exchange rate. The impact on hedging performance depends on which currency the entity in question is selling and which currency it is buying with the forward contract. Hedging an emerging market currency denominated foreign exchange risk on a five year horizon has either been systematically profitable or unprofitable throughout the sample.
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