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Testing on Unbiased Expectation Hypothesis with Panel-VEC Model

Testing on Unbiased Expectation Hypothesis with Panel-VEC Model. Fang Liu May 30,2003. Unbiased Expectation Hypothesis. Forward rate of asset is an unbiased predictor of expected future spot rate of this asset.

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Testing on Unbiased Expectation Hypothesis with 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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