Understanding spot and forward exchange rate regressions

Using the Kalman filter, we obtain maximum likelihood estimates of a permanent-transitory components model for log spot and forward dollar prices of the pound, the franc, and the yen. This simple parametric model is useful in understanding why the forward rate may be an unbiased predictor of the future spot rate even though an increase in the forward premium predicts a dollar appreciation, Our estimates of the expected excess return on short-term dollar-denominated assets are persistent and reasonable in magnitude. They also exhibit sign fluctuations and negative covariance with the estimated expected depreciation. (C) 1997 John Wiley & Sons, Ltd.