This paper tests the hypothesis that traders have rational expeatations and charge no risk premium in the forward exchange market. It uses a statistical procedure which is consistent under a large class of heteroscedasticity, and a set of data which takes into account the institutional features of the forward exchange market. The results show that inferences using this procedure are very different from those using the standard assumption of homoscedasticity.

The hypothesis that the forward rate is an unbiased predictor of the future spot rate has been rejected in many empirical studies. The rejection of this hypothesis could occur because market behavior is inconsistent with rational-expectations or because there exists a risk premium. Equations describing the forward premium and the change in the exchange rate are estimated jointly, and tests of both the rational-expectations and no-risk-premium hypotheses are conducted. Empirical estimates, obtained using quarterly data for the yen-dollar exchange rate, reject the rational-expectations hypothesis and suggest that there exists a time-varying risk premium.