The Euro exchange rate market efficiency and the risk premium: an empirical analysis with an ecm model

Abstract

The purpose of this work is to investigate the efficiency of the current Euro spot and current forward exchange rates. Within the past three decades there have been large movements in the exchange rate markets and often these movements were not related with the changes in the “fundamentals” of the economy. On the other hand, the exchange rate market efficiency implies that, if the market is efficient, there is no remaining ex ante opportunities for making profits through speculation. Hence, testing for efficiency involves the joint hypothesis of a specific risk premium and rationality. We analysed the relationship between spot and forward rates of the Euro against the British pound and the US dollar. For one of the two exchange rates (EU/UK), we reject the hypothesis of efficiency and a further analysis on the presence of a risk premium shows that it is consistent and time varying.