Inefficiencies in the Mexican Peso-U.S. Dollar Exchange Rate Market: Is it Risk Premia or Irrationality?

Abstract

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 effect 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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