A Test of Perfect Substitutability in the Foreign Exchange Market

Abstract

I. Motivations for the Test The question of whether or not domestic bonds are perfect substitutes for foreign bonds in investors' portfolios, implying that the expected rates of returns must be equalized across currencies, is an important one for two reasons. The question is crucial, first, for choosing among various models of exchange rate determination and, second, for evaluating tests of efficiency in the forward exchange market. To illuminate the first motivation, a brief discussion of models of exchange rate determination is necessary. All asset-market models share the assumption that there are no significant transactions costs, capital controls, or other impediments to the international flow of capital. Thus actual portfolios adjust instantaneously to equal desired portfolios. This implies, for example, covered interest parity: the domestic interest rate should differ from the foreign interest rate by an amount exactly equal to the forward discount rate. Perfect substitutability between domestic and foreign bonds is the stronger assumption that market participants are indifferent as to the currency composition of their portfolio. It implies uncovered interest parity: the domestic interest rate must differ from the foreign interest rate by an amount exactly equal to the expected rate of depreciation. The perfect substitutability assumption is far from standard. In fact, exchange rate models within the view can be classified into those that belong to the monetary defined by the assumption of perfect substitutability, and those that belong to the defined by the assumption of imperfect substitutability. In the portfolio-balance approach, investors hold well-defined proportions of their wealth in the form of each country's assets, with the proportions depending on the expected rates of return, as in equation (1):