Exchange rate volatility and deviations from unbiasedness in a cash-in-advance model

This paper examines time-series properties of exchange rate changes, the forward premium and the forward bias in the context of a variant of Svensson’s cash-in-advance model. The model is solved and simulated using realistic forcing processes whose law of motion is estimated from U.S.-Japan data and then approximated by a Markov chain. Although method of moments estimation shows that the over-identifying restrictions implied by the model are not rejected, it fails dramatically in producing a sufliciently variable risk premium on forward market speculation. This result is robust to various perturbations to the model’s parameters, forcing processes and preference structure. The model also fails to match exchange rate and forward premium volatility simultaneously.