Testing Whether Forward Exchange Rates Are Predictors of Future Spot Rates in Kenya
Abstract
Prior studies indicate that the predictive power of forward exchange rates for future spot
rates is weak. Fama (1976, 1984) conjectures that the low forecast power of the forward
rates is due to a failure to control the term premium embedded in forward rates. This
paper seeks to examine the hypothesis that the expected rate of return to speculation in
the Kenyan forward foreign exchange market is zero; that is, the logarithm of the forward
exchange rate is the market's conditional expectation of the logarithm of the future spot
rate. This study applies the model by Hansen and Hodrick (1980) to a data set of foreign
exchange rates of five currencies in the Kenyan foreign exchange market. The
conclusion from this study is that the forward rates are not reliable predictors of the
future spot rates. We are also able to reject the simple market efficiency hypothesis for
the exchange rates over the entire interval (December 1996 to July 2002) period.
Citation
Ndunda FK,October 2002;Testing Whether Forward Exchange Rates Are Predictors Of Future Spot Rates In Kenya.Publisher
University of Nairobi Faculty of commerce