Executive Summary

1         This paper evaluates the relative proportions of the bias in exchange rate forecasts attributed to expectation error and a time-varying risk premium, using monthly survey data for the Malaysian Ringgit, the Indonesian Rupiah, the Philippine Peso and the Thai Baht over the period December 1996 to December 1998 as a direct measure of exchange rate expectations.

2         Our analysis shows that although the forward markets anticipated the fall of the currencies, they failed to predict the timing and relative magnitudes of the subsequent depreciations. The inability of currency traders to use information optimally resulted in biased predictions of future changes in spot exchange rates. This bias is attributed to systematic forecast errors as well as variation in currency risk premia. The persistence of forecast errors suggests that the market found it difficult to read rapidly-changing economic fundamentals. This is borne out by the fact that the magnitude of the forecast error for each currency varied with the extent of macroeconomic deterioration in its respective country. In addition, we find that considerable variation in the currency risk premia over time is another source of the biased forecasts of future exchange rates. In general, the more volatile a currency is, the larger is its risk premium.

3         Large variances of expected changes in future spot rates indicate that market participants' exchange rate expectations are far from static. We test various expectation formation schemes, and find that market participants focussed mainly on recent changes in spot rates in forecasting exchange rates over a shorter term horizon. Agents on average tended to expect the future spot rate to appreciate when the current spot rates depreciated further below the spot rate of the previous period, or when the spot rate fell by more than anticipated in the previous period.