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Testing the Unbiased Expectation Hypothesis with the Panel-VEC Model

This study explores the Unbiased Expectation Hypothesis (UEH) utilizing the Panel-VEC model. It examines the hypothesis that the forward rate of an asset serves as an unbiased predictor of its expected future spot rates, under the assumption of risk-neutral investors and rational market behavior. The empirical analysis involves the Johansen Likelihood Ratio test and the estimation of cointegration relationships. We find evidence against the UEH, concluding that the forward rate does not reliably predict the expected spot rate, indicating that the hypothesis may break down in practice.

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Testing the Unbiased Expectation Hypothesis with the Panel-VEC Model

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  1. Testing on Unbiased Expectation Hypothesis with Panel-VEC Model Fang Liu May 30,2003

  2. Unbiased Expectation Hypothesis • Forward rate of asset is an unbiased predictor of expected future spot rate of this asset. general model: (1) • Assumption risk-neutral investors rational Market behavior

  3. Literature Review: Group 1 Level model of UEH (2) VECM: cointegration model for and Hakkio and Rush (1998) Barnhart and Szakmary (1991) Hai, Mark and Yu (1997) VECM: cointegration model for and , and . Eric (1999)

  4. Literature Review: Group 2 Difference model of UEH (3) Panel approach: Frankel and Froot (1991) Some stylized results return of spot rate Forward premium

  5. Testing models • Asset price • VECM

  6. Case to illustrate Panel-VEC model ITL JPY USD

  7. Assumption of model • Independent Long-run relationship • Dependency in short-run relationship: adjustment speeds short-run relationships---lags

  8. Panel-VEC model • General model

  9. Restricted model • Panel-VEC model for testing UEH = +

  10. Panel cointegration test • Johansen Likelihood Ratio (JLR) matrices are residual moment matrices from the VECM

  11. Empirical Result of JLR test • Eigenvalue and JLR

  12. Decomposition of coefficient matrix of cointegration error term • Decompose into two part: • Adjustment speed of deviation from long-run relationship = • Cointegration coefficients matrix

  13. Error term matrix • Error term

  14. Cointegration vector • Cointegration relationships

  15. Restricted model • Panel-VEC model for testing UEH = +

  16. Empirical Result of Panel-VEC model • Estimate of intercepts

  17. Slope Coefficients • Estimate of slope coefficients 1989.01-1998.12

  18. Cross-sectional dependency of adjustment speeds • Two groups {BF, DMK, FRF, ITL} {USD, CAD, JPY} Significant relationship FRF BF, DMK, ITY DMK CAD, USD JPY CAD

  19. Dependency of short-run relationship • Significant relationships JPY: BF DMK FRF ITY BF DMK FRF ITY

  20. Conclusion • Estimate of slope coefficient are not equal to unity although error terms are white noise. Therefore, forward rate is not unbiased predictor of expected spot rate, and UEH breaks down.

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