Extrapolations of future markets forward rates are a better predictor of the 30-days ahead BRL-USD exchange rate than forecasts from the Focus survey of Brazilian market participants. This is puzzling because market participants observe forward rates as they submit predictions. Dandapani and Protter (2016) describe a mechanism through which new information enlarges the information set (a filtration), changing the underlying risk neutral measure and inducing a drift into the martingale process, turning the process into a strict local martingale. We argue this mechanism can explain our rational conundrum. To empirically test the plausibility of such connection we first employ a nonparametric identification test based on Jarrow et al. (2011a),then estimate the stochastic volatility model of Andersen and Piterbarg (2007). Results suggest that Focus survey forecasts indeed display characteristics of a strict local martingale, while spot exchange rates and forward rates are con-sistent with a martingale process.
Keywords: Strict Local Martingales; Filtration Enlargement; Foreign Exchange Markets; Expectation Errors.
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