In the previous chapter our focus was the spot exchange rate. In this chapter we study the relation between forward exchange rates, spot exchange rates, and interest rates. In particular, we examine the effect of segmented commodity markets on the relation between the forward exchange rate premium and the change in the future spot rate.

The relation between forward exchange rates and future spot rates has been the subject of numerous studies. Empirical tests typically find that when one regresses changes in spot rates on forward premia, the slope coefficient is less than one and often negative. This result is called the forward bias puzzle. For example, Froot and Thaler (1990) report in their survey that the average co-efficient on the forward premium, across seventy-five studies, is –0.88. Other surveys of this literature can be found in Baillie and McMahon (1989b), Engel (1994), Hodrick (1987), Lewis (1995), and Marston (1995).

In this chapter our objective is to examine the effect of segmentation of international commodity markets on the relation between the forward premium and the change in the spot rate. Segmentation of commodity markets gives rise to PPP deviations, which are an important feature of exchange rate data. Typically, the theoretical models that have been used to analyze predictable deviations from uncovered interest parity (UIP) have assumed that PPP holds. However, empirical studies such as Bekaert (1994), Canova (1991), Gokey (1994), Levine (1989, 1991), and Mishkin (1984) find that predictable deviations from PPP are highly correlated with predictable violations of UIP; Engel (1994) provides a discussion of these tests.