TESTING THE UNBIASED FORWARD EXCHANGE RATE
HYPOTHESIS USING A MARKOV SWITCHING MODEL
AND INSTRUMENTAL VARIABLES

FABIO SPAGNOLO,ZACHARIAS PSARADAKIS AND MARTIN SOLA

SUMMARY
This paper develops a model for the forward and spot exchange rate which allows for the presence of
a Markov switching risk premium in the forward market and considers the issue of testing the unbiased
forward exchange rate (UFER) hypothesis. Using US/UK data, it is shown that the UFER hypothesis cannot
be rejected, provided that instrumental variables are used to account for within-regime correlation between
explanatory variables and disturbances in the Markov switching model on which the test is based. Copyright
 2005 John Wiley & Sons, Ltd.