Bid-Ask Spreads, Deviations from PPP and the Forward Prediction Error: The Case of the British Pound and the Euro

One puzzle in international finance is the finding that the forward foreign exchange rate is a poor predictor of the future spot foreign exchange rate. It has been postulated that this finding could be explained by the presence of unobservable risk premiums. Theory, however, is silent as to the factors that proxy for these risk premiums. Thus, we examine spot and forward bid-ask spreads and deviations from relative PPP as potential proxies. We find statistically significant evidence that deviations from relative PPP are related to the forward prediction error for the British pound and the euro. Furthermore, when examining the British pound exchange rates with the currencies of developed countries, we find that the coefficients on the bid-ask spreads are significant for the entire period. The coefficients on the bid-ask spreads of euro exchange rates with the currencies of developed countries are significant during the period 1999–2007. The findings are robust with respect to several different terms of forward rates, the consideration of transactions costs by using bid and spot rates instead of midpoint rates, and controlling for possible asymmetry and non-linearity