Testing rationality of exchange rate expectations using survey data: The case of five major currencies

Rationality of exchange rate expectations has an important implication for the efficiency of the foreign exchange market. In this dissertation, the Rational Expectation Hypothesis, in the context of the foreign exchange market, is examined for five major exchange rates. These are the Canadian Dollar/US Dollar, the Deutsche Mark/US Dollar, the Japanese Yen/US Dollar, the Swiss Frank/US Dollar and the Pound Sterling/US Dollar. The study uses twelve years of monthly survey data published by the Financial Times' Currency Forecaster, which is one of the major sources of survey data on exchange rates. Instead of using the traditional regression techniques, this study applies the more recent unit root and cointegration tests to carry out the investigation. The actual spot exchange rates and their expected rates at the one-month, three-month, six-month and twelve-month horizons have unit roots across all five exchange rates. Contrary to many other studies that used traditional econometric techniques, this study found that the one and three-month-ahead forecasts are rational for all the five exchange rates. The six-month-ahead forecast is also rational for the Pound Sterling/US Dollar exchange rate. There is some evidence of rationality of the six-month-ahead forecasts for other currencies except for the Canadian dollar/US. Dollar exchange rate. The twelve-month-ahead forecasts are not rational given the usual level of significance. The study also found that as the forecast horizons get larger, forecast errors get larger as well. The study indicates that a much longer data set may provide interesting results for the six and the twelve-month-ahead forecasts. The results found in this study have implications for government intervention in the foreign exchange market and the long-standing forward discount puzzle in the international finance literature.