Term Premia on Euro Rates.

THERE ARE AT LEAST two statistically firm results regarding international money and capital markets. The first is the theory of interest rate parity is empirically valid for Euro interest rates [8]. The second is forward exchange rates are poor, very likely biased, predictors of future spot exchange rates. The former is a comforting finding in that it assures there are no unexploited arbitrage profits. The latter is troubling (to some) because it might be a symptom of an inefficient market. That interest rate parity holds suggests international exchange and money market arbitrageurs are fully exploiting all profit opportunities. They are behaving rationally. That forward exchange rates fail to predict future spot rates at least unbiasedly suggests the existence of some unknown mechanism which robs predictive ability. In a naive rational expectations view of the world, the failure of forward rates to be unbiased predictors of future spot rates implies either that there is some difference between interest rate pairs other than inflationary expectations, or that forward tares do not capture expected inflation differences in any simple way. This paper addresses the first issue. If there are differences in interest rate pairs which do not solely reflect expected inflation divergences, this must show up as a difference in real interest rates. Such could be the result of actual instantaneous real rates of identical risk being unequal in magnitude, or what is more likely, differences in term premia between interest rate pairs when periods greater than, say, one day are used in interest rate parity and forward rate prediction tests. If there are differential term premia in interest rate pairs of, say, one month or longer then forward exchange rates will mispredict the future spot exchange rate by that margin. [ABSTRACT FROM AUTHOR]