Testing Whether Forward Exchange Rates Are Predictors of Future Spot Rates in Kenya

Abstract

Prior studies indicate that the predictive power of forward exchange rates for future spot rates is weak. Fama (1976, 1984) conjectures that the low forecast power of the forward rates is due to a failure to control the term premium embedded in forward rates. This paper seeks to examine the hypothesis that the expected rate of return to speculation in the Kenyan forward foreign exchange market is zero; that is, the logarithm of the forward exchange rate is the market's conditional expectation of the logarithm of the future spot rate. This study applies the model by Hansen and Hodrick (1980) to a data set of foreign exchange rates of five currencies in the Kenyan foreign exchange market. The conclusion from this study is that the forward rates are not reliable predictors of the future spot rates. We are also able to reject the simple market efficiency hypothesis for the exchange rates over the entire interval (December 1996 to July 2002) period.