Three Roles of the Forward Foreign Exchange Market

Abstract

This paper sutdies the behavior of a foreign exchange trader in the forward foreign exchange market. The foreign exchange trader, who may be an export/import trading merchant, an international investor, or a commerical bank portfolio manager, is assumed to receive or pay fixed amounts of domestic and foregin currencies at a specified future date. Facing an uncertain spot exchange rate that will prevail on the future maturity date, he attempts to fix his foreign currency claims or obligaions in terms of the domestic currency by entering into a forward contract. Section II discusses the expected utility maximizing behavior or a risk averse foreign exchange trader and obtains the first order condition. It is shown in Section IIthat, if the foreign exchange trader's terminal wealth derived from all soruces other than foreign exchange transactions (spot and forward) in subject to uncertainty, then his demand for forward contracting can be decomposed into three distinctive parts--pure hedgeing, speculative hedging and pure speculation. Importance of pure hedging and pure speculation has been emphasized in the literature, but the concept of speculative hedging has not been fully investigated. Effects upon pure speculation of increases in absolute risk aversion, wealth, the expected spot rate and exchange rate uncertainty will be scrutinized in Section IV.