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New Zealand's foreign exchange market and the nature of expectations

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  • David Rae

Abstract

This paper confirms the forward premium puzzle, or the failure of uncovered interest parity, in New Zealand's foreign exchange market. The rejection of the risk-neutral rational expectations hypothesis is traced to two sources. First, there is evidence of a time-varying and possibly non-stationary risk premium in the forward market, and this premium appears related to volatility in the spot NZD market. Second, survey data is used to show that exchange rate expectations are not rational. The paper speculates that exchange rate expectation errors may be related to systematic errors in forecasting inflation or the stance of monetary policy. Exchange rate expectations are revised following inflation 'surprises' but these inflation surprises themselves show systematic patterns and therefore rationality of inflation expectations can also be rejected. There is also evidence that a lack of full credibility of the central bank's inflation targeting regime may have affected inflation expectations, and therefore be a factor in the apparently non-rational behaviour of the forward market.

Suggested Citation

  • David Rae, 2000. "New Zealand's foreign exchange market and the nature of expectations," New Zealand Economic Papers, Taylor & Francis Journals, vol. 34(2), pages 221-241.
    • Handle: RePEc:taf:nzecpp:v:34:y:2000:i:2:p:221-241
    DOI: 10.1080/00779950009544324
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    References listed on IDEAS

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    1. Hai, Weike & Mark, Nelson C & Wu, Yangru, 1997. "Understanding Spot and Forward Exchange Rate Regressions," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 12(6), pages 715-734, Nov.-Dec..
    2. Hasan Bakhshi & Anthony Yates, 1998. "Are UK inflation expectations rational?," Bank of England working papers 81, Bank of England.
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    Cited by:

    1. Holmes, Mark J. & Dutu, Richard & Cui, Xiaoman, 2009. "Real interest rates, inflation and the open economy: A regime-switching perspective on Australia and New Zealand," International Review of Economics & Finance, Elsevier, vol. 18(2), pages 351-360, March.

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