Abstract
It is well known that the forward exchange rate and the realised future spot exchange rate differ. This phenomenon is better known as the exchange rate puzzle. Two approaches were followed to ascertain whether this difference is due to the weak explanatory ability of current economic fundamentals or whether the use of an ineffective econometric approach to model exchange rate theories is to blame. The first approach makes use of stationary economic time series data to model the ZAR/USD realised future spot exchange rate, while the second uses non-stationary level economic data to model the ZAR/USD realised future spot exchange rate. While the first approach reported weak results, the second approach illustrated that economic fundamentals are able to explain the ZAR/USD realised future spot exchange rate. These results also confirm that the exchange rate puzzle is a pseudoproblem.
Highlights
The value of the South African Rand (ZAR) is still experiencing extensive swings under the freely floating exchange rate regime
Most academic studies focus on the economic fundamentals that can possibly explain the forward exchange rate on the date that the forward exchange rate contract matures, without even mentioning the mechanistic price formulation methodology used in the foreign exchange markets
This study provides a solution for the exchange rate puzzle through the formulation of a model that has the ability to explain the realised future spot exchange rate better than the current forward rate methodology
Summary
The value of the South African Rand (ZAR) is still experiencing extensive swings under the freely floating exchange rate regime. The large difference between the forward exchange rate and the ZAR/USD spot exchange rate makes this approach ineffective for market participants. The reason is that the current method used by South African banks to quote the forward exchange rate is a mechanical approach This is a fact that seems not to be widely known or recognised, especially by academics. This paper will incorporate the interactions of the international financial markets into an exchange rate model as an additional economic fundamental to explain the realised future spot exchange rate. This alternative approach attempts to incorporate market expectations more effectively.
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