Speculation and the Forward Foreign Exchange Rate: A Note

Abstract

ONE OF THE MOST widely used models dealing with the effects of speculation on the forward foreign exchange rate is the so-called Modern Theory of the Forward Foreign Exchange Rate which stresses the role of both interest arbitrage and speculation in the determination of the forward rate (see Grubel [2]). Traditionally, the reduced form of the model expresses the forward foreign exchange rate as a weighted average of the covered interest-parity exchange rate on one hand and of the future spot rate expected to prevail at the maturity date of the forward contract on the other hand. Empirical work based on this reduced form is found in Stoll [6], Kesselman [4], Haas [3], and McCallum [5]. This specification, in which speculation on the forward foreign exchange market is implicitly analyzed in terms of the current forward exchange rate and the expected future spot exchange rate only, is unduly restrictive. The options facing the speculator are indeed much broader. The speculator does not need to get out of his speculative position by buying or selling the relevant currency on the spot market at the date of delivery. He can take his gain at any time between the date of the initial contract and the delivery date by entering into an offsetting transaction on the forward market for the same delivery date as soon as the corresponding forward rate is lower than the rate at which he sold forward initially. For example, a speculator expecting a depreciation of sterling and having sold forward sterling in January at $2.00 for delivery in July may take his gain by buying the sterling forward in April if at that time the three-month forward rate of sterling is, say, $1.85. The possibility to speculate by combining two offsetting forward transactions contracted at two different moments in time but for the same delivery date, without any operation on the spot market at that date, has an important implication: the expected future spot rate is not the only key variable determining speculators' decisions. Speculators can decide to speculate on a future forward rate, following exactly the same principles as when speculating on the future spot rate. They will thus sell forward foreign exchange if the current forward exchange rate is higher than the expected value of a future forward rate for contracts involving the same delivery date, and buy forward in the opposite case. If, for example, speculators anticipate that, in three months, the three-month forward exchange rate for sterling will be lower than the present forward exchange for sixmonth contracts, they expect to make a speculative gain by selling sterling today on the six-month forward foreign exchange market and buying sterling forward