Although it is firmly established that expectations play a central role in the determination of exchange rates, little is known about the exact nature of those expectations. Of course, the problem with empirically testing hypotheses about exchange rate expectations is that expectations are unobservable. In the past, a popular way to get around this problem was to use either the forward exchange rate or the ex post spot exchange rate as a proxy for the expected exchange rate.
There is an obvious drawback to this approach. First, the use of the forward exchange rate presupposes that there is no risk premium, but the absence of a risk premium itself is a hypothesis of interest.1 Second, the use of the ex post exchange rate imposes rationality of expectations, but the nature of expectations can only be determined empirically. Most empirical tests involving exchange rate expectations are thus joint tests of a hypothesis about the degree of risk aversion (or a more structural model of exchange rate determination) and a hypothesis about the nature of expectations.
In order to avoid the joint nature of conventional hypothesis testing, an increasing number of researchers have recently begun to use survey data in tests involving exchange rate expectations. The use of observable survey expectations allows separate testing of an underlying model of exchange rate determination and a hypothesis about expectations. There is strong professional resistance to the use of nonmarket data, perhaps for good reasons. For one thing, there is no assurance that economic agents have enough incentive to disclose their truthful expectations. For another, even if they did, no precise link seems to exist between average (or individual) expectations and the actual exchange rates that are in fact marginal prices in the foreign exchange market. However, in the absence of better alternatives, an empirical literature based on survey data of exchange rate expectations has been expanding in recent years. This paper presents a brief survey of this growing literature.
The paper is organized as follows. Section I summarizes the features of five major sets of survey data used in the literature. Section II presents a few characteristics of survey exchange rate expectations. Sections III–VI survey, respectively, major empirical results on forward discounts and risk premia, the rationality of expectations, the mechanism of expectations formation, and the relationship between short-run and long-run expectations. The concluding section presents a summary and a few policy implications.
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For example, if there is no risk premium in the exchange rate of any two currencies, assets denominated in one currency are perfect substitutes for those denominated in the other, making sterilized foreign exchange market intervention ineffective.
Note that expectations (expressed by the operator E) may or may not be mathematical expectations.
Her study also included the Swiss franc and two-week expectations.
Boughton (1988) suggests an interesting possibility that short-run and long-run markets are segregated in terms of market participants. According to this interpretation, the expectations of foreign exchange participants in each market can be rational even it they are not consistent with those in the other market.
The rejection may also reflect the so-called peso problem which is a finite sample bias attributable to the failure of correct expectations to materialize during the sample period. In the earlier period of dollar appreciation, for example, the consistent bias in expectations might have reflected the expectations of rational agents who correctly perceived the dollar to be “too high.”