The Effect of Errors in Variables on Tests for a Risk Premium in Forward Exchange Rates



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    • Wells Fargo Bank, San Francisco. I am indebted to Steven W. Kohlhagen and David Hsieh for a number of helpful comments on an earlier version of this paper.


Conventional tests for a risk premium in the price of forward exchange use the subsequently realized spot rate as a proxy for prior expectations. Use of this proxy creates a serious errors-in-variables problem which makes it difficult to reject the null hypothesis of zero risk premium. Use of a better proxy for expectations indicates the presence of a risk premium in the forward exchange rate of all countries analyzed.