Market-based Forecasting: The Spot and Forward Exchange Rates

Abstract

This chapter deals with market-based forecasting that involves using the current spot and forward exchange rates to forecast the spot rate at some future point in time. This is called market-based forecasting because the forecasters (the spot and forward rates) are provided by the spot and forward foreign exchange markets. Market-based forecasting rests on two hypotheses: the random walk hypothesis and the unbiased efficiency hypothesis. The random walk hypothesis tells us that period-to-period changes in the spot exchange rate are random and unpredictable. The spot exchange rate tomorrow is as likely to be above today’s level as to be below it. Hence, the best forecast for tomorrow’s exchange rate is today’s rate. The unbiased efficiency hypothesis tells us that the current spot rate is an unbiased and efficient forecaster of the spot exchange rate prevailing on the maturity date of the forward contract. This is because the exchange rate supposedly reflects the market’s expectation of the level of the spot rate in the future. The importance of these forecasters (the spot and the forward exchange rates) is that they are used as benchmarks to evaluate the forecasting performance of the models presented in the previous two chapters. The question is always whether or not a particular model can outperform the random walk model or the forward rate. The two hypotheses also have implications for market efficiency. The random walk model implies that the spot market is weakly efficient, while the unbiased efficiency hypothesis implies efficiency of both the spot and forward markets. All of these issues will be discussed in this chapter.