Common stochastic trends between forward and spot exchange rates

The common trend analyses between the forward rate (F-t) and the corresponding future spot rate of the same currency (St+1) have raised several issues: notably, the sensitivity of the cointegrating relation to a constant term and lag lengths and the non-stationarity of the risk premium. This paper addresses these issues more rigorously using the daily exchange rate of the pound Sterling vis-a-vis five major currencies viz. the Canadian dollar, French franc, German mark, Japanese yen, and US dollar. The appropriate deterministic term in the cointegrating space is identified through empirical tests. A robust cointegrating relation is found between F-t and St+1; however, the hypothesis of unbiasedness of forward rate could not be sustained. An alternative measure of risk premium is suggested and its stationarity is confirmed. (C) 1998 Elsevier Science B.V. All rights reserved.