DEFAULT RISK AND THE DEMAND FOR FORWARD EXCHANGE

Abstract

This chapter discusses default risk and the demand for forward exchange. The development of the so-called modern theory (MT) of the forward foreign exchange market purports to offer at least three contributions. First, it establishes that forward exchange market equilibrium can occur at a forward rate that does not correspond to interest rate parity (IRP). Second, it predicts usefully for forecasting purposes that the equilibrium forward rate invariably falls in between the IRP forward rate and the expected future spot rate. And third, it supplies a theoretical foundation for government policies of intervention in the forward market that are deemed—given certain assumptions regarding speculators' expectations as to the results of the intervention—to be potentially successful even under market demand conditions that are such as to produce IRP. The several deficiencies of the MT stem essentially from its treatment of the forward exchange market as a closed system, isolated from other markets. The urge to identify the equivalent of demand and supply sides in the market forced many authors to posit an artificial segmentation of forward market transactions, as between pure arbitrage and pure speculation: arbitrageurs never speculate and vice versa.