Testing the rationality of expectations in the Australian foreign exchange market using survey data with missing observations

This paper is concerned with testing the rationality of exchange rate expectations in the Australian foreign exchange market when there are missing observations in the survey data on expectations due to National or other holidays. The survey data analysed contains weekly observations on 1-week and 4-week ahead forecasts of the $US/$A and the Yen/$US exchange rates. The analysis proceeds by (i) examining the time series properties of the actual and expected exchange rates; (ii) investigating whether the cointegrating relationship between the actual and expected exchange rates suggested by the rational expectations hypothesis is satisfied; and (iii) for those cases where the appropriate cointegrating relationship is observed, testing for rationality using the forecast errors. In each of these steps, the problem of missing observations is addressed. Kalman filter techniques suggested by Harvey and Pierse (1984) are used to estimate the appropriate ARIMA models in each step. Results in steps (i) - (iii) are presented for two cases: when the problem of missing observations is ignored; and when appropriate techniques are used to deal with missing observations.