Testing the unbiased forward exchange rate hypothesis using a Markov switching model and instrumental variables

This paper develops a model for the forward and spot exchange rate which allows for the presence of a Markov switching risk premium in the forward market and considers the issue of testing the unbiased forward exchange rate (UFER) hypothesis. Using US|UK data, it is shown that the UFER hypothesis cannot be rejected, provided that instrumental variables are used to account for within-regime correlation between explanatory variables and disturbances in the Markov switching model on which the test is based. Copyright © 2005 John Wiley & Sons, Ltd.