Nonlinearity And The Forward Premium Anomaly

Abstract

Speculative efficiency (the ability to profit without bearing commensurate risk in foreign exchange markets) is predicated on the forward premium anomaly. Market efficiency still manifests itself in the form of nonlinear adjustments, eroding excess profits. The returns on foreign exchange speculation may not behave in a market-efficient manner except at average values of interest-rate differentials. This study suggests that market efficiency holds as a result of a hedging relation between linear and nonlinear responses of returns.