Abstract
This paper presents a multiperiod rational-expectations model of a foreign exchange market in order to analyze the effect of introducing currency forward trading on measures of exchange-rate volatility. Based on an optimizing approach to risk-average agents, it highlights how commercial traders and interest arbitrageurs behave facing exchange risk and forward contracting opportunities. It is found that forward trading tends to stabilize spot exchange rates if the trade disturbance is the predominant random factor in the market, while it exacerbates spot-rate variability if the disturbance in the interest rate differential is the chief stochastic element.
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