Tests of Rational Expectations in the Forward Exchange Market

Abstract

This paper presents tests of the hypothesis that, during the current period of floating exchange rates, the forward rate has been equal to the expected future spot rate. These are tests of rational expectations if there are no transactions costs or risk premia. Progressively broader definitions of the information set (upon which expectations are conditional) are taken. When the sample period is started in mid-1974, rather than in early 1973, the deutsche mark passes all tests. Other currencies, such as the seth thpound, fail one or more tests. A statistical rationale for this finding, involving the possibility of discontinuously large errors, is suggested.