Handbook of Exchange Rates

8.9 Acknowledgments

The authors are grateful to Lucio Sarno and an anonymous referee for useful comments.

¹The assumption of integrated fundamentals of order 1 is widely accepted in the literature. The assumption that the discount factor is close to 1 has been empirically validated by Sarno and Sojli (2009).

²Note that we will not be discussing two recent approaches to predicting movements in exchange rates: (i) the microstructure approach that depends on order flow as a measure of net buying pressure for a currency (Evans and Lyons, 2002; Rime et al., 2010) and (ii) the global imbalances approach (Gourinchas and Rey, 2007, and Della Corte et al., 2012).

³The argument still follows if the home country also targets exchange rates. It is standard to omit the exchange rate target from Equation (8.3) on the interpretation that US monetary policy has essentially ignored exchange rates (Engel and West, 2005).

⁴An alternative way of testing UIP is to estimate the “Fama regression” (Fama, 1984), which conditions on the forward premium. Note that if covered interest parity (CIP) holds, the interest rate differential is equal to the forward premium and testing UIP is equivalent to testing for forward unbiasedness in exchange rates (Bilson, 1981). For recent evidence on CIP see Akram et al. (2008).

⁵Clarida et al. (2003, 2006) and Boudoukh et al. (2006) also show that the term structure of forward exchange (and interest) rates contains valuable information for forecasting spot exchange rates. ...