International Finance Essay Example | Topics and Well Written Essays - 1500 words - 3

International Finance - Essay Example When used in a data set of 7 major currencies in the post-Bretton Woods age, the JLR test offers strong and credible evidence in support of a unitary cointegrating vector in between forward and corresponding future spot rates. However, the orthogonality condition is met only for 3 major currencies. According to the forward rate unbiasedness hypothesis (FRUH), â€Å"under conditions of risk neutrality and rational expectations on the part of market agents, the forward rate is an unbiased predictor of the corresponding future spot rate†. Assuming the absence of a risk premium in the foreign exchange market, it must hold true that Johansen (1992) puts forward a maximum likelihood technique to establish the number of common trends in a system of unit-root variables. Without any generality being lost, a p -dimensional vector autoregressive (VAR) process of k -th order can be written as: To test the hypothesis in (6), it suffices to test that the smallest of the characteristic roots of ÃŽ   is zero, as a rejection necessarily implies that all characteristic roots of ÃŽ   are nonzero and therefore ÃŽ   possesses full rank. Such a test can be constructed on the basis of the following test statistic, referred to as the Johansen likelihood ratio (JLR) test statistic: The paper analyzed U.S. dollar spot and 90-day forward rates for 8 major currencies: Canadian dollar (CD), Deutsche mark (DM), British pound (BP), French franc (FF), Swiss franc (SF), Netherlands guilder (NG), and the Italian lira (IL). The sample period is from 1974:3 to 1996:4 at a quarterly frequency. Since the maturity date of the forward contract and the sampling frequency are similar, problems emanating from the use of overlapping data are bypassed. The 90-day forward rates are matched with the corresponding future spot rates and