The efficiency of the peso-dollar exchange rate market is evaluated for
the period 1997-2007. Considering the term structure of interest rates,
this study finds that the efficient market hypothesis implied in the covered and
uncovered interest parity fails to hold for the peso-dollar exchange rate
market. With the help of survey data on peso-dollar exchange rate, deviations from
efficiency are allocated to a risk premium e¤ect and expectational errors by the
method developed by Frankel and Froot (1989).
The results from this allocation indicate that the observed departures
from efficiency in the peso-dollar exchange market capture both a
time-varying risk premium and systematic errors in expectations. Risk premium induces
investors to over-predict realized depreciation along the entire term structure;
whereas, expectational errors exhibit a particular term structure. In the
short-run, they lead to over-predict depreciation and in the long-run to under-predict
it, counteracting the risk premium effect.
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