The Behavior of Professional Risk-Bearers: Test of a Theory: Comment

Abstract

nebulous nature of exchange rate expectations and speculation has posed a severe handicap to empirical studies of foreign exchange markets. desire to circumvent this problem has led to numerous attempts by economists to specify an objective indicator of such speculative behavior. Perhaps the most formalized of these guides was derived by Jerome Stein.l This objective indicator of the speculative behavior of professional risk-bearers has been tested by Fred Glahe [2] . However, the benchmark utilized by Glahe in his test of Stein's theory is inappropriate. purpose of this note is to illuminate this defect and provide an alternative test of Stein's theory. In contrast to the abstract analysis of most writers on forward-exchange theory, Stein provided a highly institutionalized approach to the forward market in his monograph The Nature and Efficiency of the Foreign Exchange Market. Rather than develop a model of the idealized market participants, Stein's analysis was based on various features of the existing institutional framework of the forward market. His exposition described the role of large banks as professional risk-bearers (i.e., speculators), the speculative role of commercial traders through leads and lags in their spot market transactions, covered interest arbitrage, and covered foreign borrowing. An important implication of this institutional setting is that only the large banks can speculate in the forward market while all other speculators are restricted by bank practices to the spot market. Combining this institutional framework with the observation that there is one pattern of price behavior that results from random variations in the balance of payments; and a different pattern of price behavior that results the market thinks that changes in the exchange rates will occur in the near future [4, p. 5] provides the foundation upon which Stein built his indicator of the speculative behavior of the professional risk-bearers. operational indicator devised by Stein is designed to indicate the behavior of the professional risk-bearers not only during speculative periods, i.e., when the