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Introduction
The weakform efficiency hypothesis of foreign exchange markets presents
testable implications for the time series behavior of systems of spot currency rates.1
Researchers’ empirical findings of cointegration in systems of spot exchange rates
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(Alexander and Johnson (1992), Lopez (1996), and
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Baillie and Bollerslev (1989, 1994a),
inter alia) would seem to contradict the market efficiency hypothesis, since a
cointegrated system necessarily implies the presence of predictability of returns in at
least one currency.2, 3
Does the existence of cointegration among spot rates imply a rejection of the
market efficiency hypothesis?4 Crowder
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Using daily data for four currencies, Crowder (1992) finds that
forward premium series are nonstationary processes. Crowder (1994) confirms such
unitroot evidence for monthly forward premium series for three currencies, and
concludes that the data do not support the market efficiency hypothesis.
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Luintel and Paudyal (1998)
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find daily forward premium series for five currencies to be
realizations of unitroot processes, while Horvath and Watson (1995) and Clarida
and Taylor (1997) reach the conclusion that forward premiums are stationary
processes.
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Given equation (4), the integration order of the forward premium has
direct implications for the stochastic structure of the currency risk premium and,
consequently, for foreign exchange market efficiency.
3. The Johansen Likelihood Ratio (JLR) Test
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Johansen (1992)
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suggests a maximum likelihood method to determine the
number of common trends in a system of unitroot variables. Without any loss of
generality, a p –dimensional vector autoregressive (VAR) process of k–th order can
be written as follows:
∆tX = μ +1Θt−1∆X + ... + k−1Θt−k+1∆X + t−kΠX + tε (5)
where ∆ is the firstdifference operator, μ is a (p x 1) matrix of co
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Taylor
and Sarno (1998) show that the JLR test statistic in (8) is asymptotically distributed as
χ21() under the null hypothesis.
The JLR multivariate test employed here offers important methodological
advantages over firstgeneration panelunit root tests proposed by Levin and Lin
(1992, 1993),
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Im et al. (1995),
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O'Connell (1998), and others. Such tests have as their
null hypothesis that all variables in the panel are realizations of unitroot processes.
Hence, this null will be rejected if even one of the series in the panel is stationary.
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13130
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The JLR multivariate test employed here offers important methodological
advantages over firstgeneration panelunit root tests proposed by Levin and Lin
(1992, 1993), Im et al. (1995), O'
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Connell (1998), and
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others. Such tests have as their
null hypothesis that all variables in the panel are realizations of unitroot processes.
Hence, this null will be rejected if even one of the series in the panel is stationary.
 (check this in PDF content)