Abstract
This chapter examines in some detail the behaviour of spot and forward exchange rates. We show that combining covered interest parity (CIP) with the common and seemingly innocuous assumptions of rational expectations and risk neutrality quickly results in powerful conclusions regarding the relationship between spot and forward rates. This combination os usually interpreted as a joint hypothesis (of an arbitrage condition and expectations formation). Nevertheless, empirical evidence detailed in section 2.1 shows that these conclusions are rejected by the vast majority of researchers. Subsequent sections present theoretical and empirical tests of each of the building blocks featured in the joint hypothesis in order to determine the sources of the rejection. We detail the findings of previously published research and supplement it where necessary with new work of our own.
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MacDonald, R., Marsh, I. (1999). Spot and Forward Market Relationships. In: Exchange Rate Modelling. Advanced Studies in Theoretical and Applied Econometrics, vol 37. Springer, Boston, MA. https://doi.org/10.1007/978-1-4757-2997-9_2
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