Explaining Bias in the Foreign Exchange Market : The Case of Traded Volatility and Fractional Cointegration

The persistence of the forward premium has been cited both as evidence of the failure of the unbiasedness hypothesis and as rationale for the forward premium anomaly. Exploring the nature of this may provide useful insights into issues of market efficiency. This paper examines the proposition that the forward premium and the conditional variance of the spot rate are fractionally cointegrated using traded volatility as a measure of the latter. A corollary of the results is that the risk premium is non-stationary. Although non-standard, it is not inconsistent with risk premia derived from sticky-price general equilibrium models