Unveiling the Potential of PPP Theory: A Practical Approach to Short-Term BDT-USD Exchange Rate Forecasting in Bangladesh

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

This paper re-considers cointegrating behaviour between forward and spot exchange rates and the implications for the forward rate unbiasedness hypothesis. Extant empirical evidence examining forward and future spot rates is mixed, offering results both for and against cointegration; the forward rate as an unbiased predictor of the spot rate; and the existence of a time-varying risk premium. However, recent research has suggested that such analysis may be subject to bias and that models of cointegration between forward and current spot rates should instead serve as a starting point for analysis of exchange rate behaviour. Johansen cointegration analysis supports this contention showing that erroneous inferences can be made by merely using future spot rate data. Subsequently both single equation and panel estimation methods support cointegration between forward and current spot rates, but that the forward rate is a biased predictor. Further, single equation tests are conducted over a rolling window of five ...

The Unbiased forward rate hypothesis (UFRH) stipulates that the forward rates should be a perfect predictor for the future spot rates. A number of studies conducted in order to test the UFRH and foreign market efficiency, have come to the conclusion that the hypothesis does not hold. This phenomenon is dubbed as the UFRH puzzle. A number of studies that reject the UFRH have made use of ordinary least square methods and support a linear adjustment between spot and forward exchange rates. This paper establishes that the use of a linear model in testing the UFRH can lead to a misspecification problem if indeed there is a nonlinear adjustment between the forward and spot exchange rates. In order to overcome the problem of model misspecification, this paper applies the nonlinear method of the class of the Smooth Transition Regression (STR) model in assessing the relationship between the rand-US dollar future spot and forward exchange rates. With the aid of a series of diagnostic tests, the paper shows that there is indeed a nonlinear adjustment process between the rand-US dollar spot and forward exchange rates and that there exists a regime in the STR model where the UFRH eventually holds.

This paper analyzes the stationarity of spot and forward exchange rates by testing for the presence of unit roots in the autoregressive process of the exchange rate time series. The results of the unit root and cointegration tests for forward exchange rates of six major currencies are inconsistent with earlier studies by others that found the existence of unit roots but the absence of cointegration. Our results show that realized spot rates are cointegrated with past forward rates. Both Dickey-Fuller and Augmented Dickey-Fuller tests affirm the unbiased forward rate hypothesis for 30- and 90-day forward rates. The Augmented Dickey-Fuller tests on the longer term forward rate, however, reveal the existence of cointegration that leads to the rejection of the hypothesis.

In this research, monthly forward exchange rates are evaluated for possible existence of time varying risk premia in Singapore forward foreign exchange rates against US dollar. The time varying risk premia in Singapore dollar is modeled using non-Gaussian signal plus noise models that encompass non-normality and time varying volatility.The results from signal plus noise models show statistically significant evidence of time varying risk premium in Singapore forward exchange rates although we failed to reject the hypotheses of no risk premium in the series. The results from Gaussian versions of these models are not much different and are in line with Wolff (1987) who also used the same methodology in Gaussian settings.Our results show statistically significant evidence of volatility clustering in Singapore forward exchange rates. The results from Gaussian signal plus noise models also show statistically significant evidence of volatility clustering and non-normality in Singapore forward foreign exchange rates. Additional tests on the series show that exclusion of conditional heteroskedasticity from the signal plus noise models leads to false statistical inferences.

Focused on the exchange rate determination in the short-run and the long-run. The analyses were conducted under the the flexible exchange rate regime in Thailand from July 2, 1997 to February 18, 1998. This study analyzed the efficiency of the foreign-exchange market by examning the relationship between spot and forward exchange rates. Besides, it analyzed whether the deviations in actual and expected interest differentials, which reflected news, could be significant in determining the spot rates. Furthermore, it tested the relationship between the exchange rates and the price level by examining patterns of deviasions from purchasing power parities. This model used the data on a monthly basis from January 1994 to November 1997. The ordinary least squares method was used in the first and second analyses use and the results revealed that the foreign-exchange market was inefficient and the forward rate is not unbiased estimator of the future spot exchange rate. Further, both of news and the forward rate in previous period were not influencial in changes in the spot rate. The result also showed that the pattern of deviations from purchasing power parities could be characterized by the first-order autoregressive process.

This paper explores how consistent two-dimensional families of forward rate curves can be constructed on an international market. Applying the approach in Björk and Christenssen (1999) and Björk and Svensson (2001), we study when a system of inherently infinite dimensional domestic and foreign forward rate processes in a two-country economy with spot (forward) exchange rate possesses finite dimensional realizations. In the system with the forward exchange rate, the forward interest rate equations are supplemented by a third infinite dimensional stochastic differential equation representing the forward exchange rate dynamics. We construct and fit consistent families to observed Euro and USD yields as well as the forward (spot) EUR/USD exchange rate.

This chapter deals with market-based forecasting that involves using the current spot and forward exchange rates to forecast the spot rate at some future point in time. This is called market-based forecasting because the forecasters (the spot and forward rates) are provided by the spot and forward foreign exchange markets. Market-based forecasting rests on two hypotheses: the random walk hypothesis and the unbiased efficiency hypothesis. The random walk hypothesis tells us that period-to-period changes in the spot exchange rate are random and unpredictable. The spot exchange rate tomorrow is as likely to be above today’s level as to be below it. Hence, the best forecast for tomorrow’s exchange rate is today’s rate. The unbiased efficiency hypothesis tells us that the current spot rate is an unbiased and efficient forecaster of the spot exchange rate prevailing on the maturity date of the forward contract. This is because the exchange rate supposedly reflects the market’s expectation of the level of the spot rate in the future. The importance of these forecasters (the spot and the forward exchange rates) is that they are used as benchmarks to evaluate the forecasting performance of the models presented in the previous two chapters. The question is always whether or not a particular model can outperform the random walk model or the forward rate. The two hypotheses also have implications for market efficiency. The random walk model implies that the spot market is weakly efficient, while the unbiased efficiency hypothesis implies efficiency of both the spot and forward markets. All of these issues will be discussed in this chapter.

SUMMARY This paper provides a robust statistical approach to testing the unbiasedness hypothesis in forward exchange market efficiency studies. The methods we use allow us to work explicitly with levels rather than differenced data. They are statistically robust to data distributions with heavy tails, and they can be applied to data sets where the frequency of observation and the futures maturity do not coincide. In addition, our methods allow for stochastic trend non-stationarity and general forms of serial dependence. The methods are applied to daily data of spot exchange rates and forward exchange rates during the 1920s, which marked the first episode of a broadly general floating exchange rate system. The tail behaviour of the data is analysed using an adaptive data-based method for estimating the tail slope of the density. The results confirm the need for the use of robust regression methods. We find cointegration between the forward rate and spot rate for the four currencies we consider (the Belgian and French francs, the Italian lira and the US dollar, all measured against the British pound), we find support for a stationary risk premium in the case of the Belgian franc, the Italian lira and the US dollar, and we find support for the simple market efficiency hypothesis (where the forward rate is an unbiased predictor of the future spot rate and there is a zero mean risk premium) in the case of the US dollar.

Forward exchange rates and expectations during the 1920s: A re-examination of the evidence

V článku jsou popsány postupy, jakými lze oceňovat potenciální či vzniklé pohledávky a závazky, jejichž velikost závisí na úrokových sazbách (referenčních úrokových sazbách - např. 1M USD LIBOR) či referenčních měnových kurzech. V článku je popsán postup, jakým lze oceňovat podmíněné toky plateb mající charakter úrokových či měnových OTC opcí. Čtenáři jsou přiblíženy postupy pro odhad forwardových úrokových sazeb a forwardových měnových kurzů a je ukázáno, jakým způsobem lze odhadnuté forwardové úrokové sazby a forwardové měnové kurzy použít při ocenění OTC opcí - evropských a amerických měnových call a put opcí, asijské (průměrné) úrokové opce a úrokového cap a floor. Dále je ukázán způsob, jakým lze přistupovat k ocenění třídy tzv. úrokových a měnových forwardů a úrokových a měnových futures. V práci uvedené postupy nevyžadují používání binomického ani Black-Scholesova modelu oceňování opcí, což velmi usnadňuje používání v článku uvedených oceňovacích postupů.

Stationary time-varying risk premia in forward foreign exchange rates

Taiwan is the type of island economy that highly depends on foreign trade. The trade between Taiwan and Japan is frequent and close due to the advantage of geographical position and similarities in culture. The trade deficit between Taiwan and Japan has expanded day by day and continued for a long time. A lot of research discussed the reasons of the trade deficit and strategies to the solution have been carried out. According to international trade theory, the exchange rate is an important factor influencing trade. Therefore, this paper tries to discuss the interaction between exchange rates and relative price level in the two countries and also consider its time lag. This paper is constructed under the framework of Purchasing Power Parity (PPP) theory. We use the approach of a multi-variable spectral analysis of frequency domain to discuss the causal relationship and time lag between nominal rate and relative price level. Then we use the methods of regression in time series to analyze and reexamine them. The beginning of this empirical data is after the liberalization of the exchange rate in Taiwan in January 1991 and ends in December 2007. The theory of Purchasing Power Parity (PPP) states that exchange rates between any two currencies will adjust to reflect changes in the relative price levels of the two countries. The PPP hypothesis has been rejected in the short run by numerous studies. Whether or not such a relationship holds in the long run, however, has also not been without controversy in relevant literature. There is a lot of research on PPP theory which have made a significant contribution by applying different statistic techniques. However, these analytical approaches are confined to the time domain including regression, single variable correlation and integration analysis.

A Re-Examination of the Forward Exchange Rate Unbiasedness Hypothesis. — This paper applies the Phillips and Hansen estimation and inference procedures to re-examine the hypothesis that the forward exchange rate is an unbiased predictor of the future spot exchange rate. The results indicate that the 90-day forward exchange rate is not an unbiased predictor. However, the 90-day forward and future spot exchange rates are cointegrated. Only for the U.K. pound/U.S. dollar exchange rate is there an error correction representation. Overall, however, the evidence is consistent with the hypothesis that risk-averse agents in the forward foreign exchange market form expectations rationally.

Forward foreign exchange rates and risk premia—a reappraisal