Forward Exchange Market Research Articles

A dynamic econometric analysis of the dollar-pound exchange rate in an era of structural breaks and policy regime shifts

We employ a newly-developed partial cointegration system allowing for level shifts to examine whether economic fundamentals form the long-run determinants of the dollar-pound exchange rate over a recent period characterised by structural breaks and policy regime shifts. The paper models both long-run and short-run dynamic features of the exchange rate using a set of economic variables that explicitly reflect quantitative monetary policy and the influence of a forward exchange market. Out-of-sample forecasts comparing the model with economic fundamentals to benchmarks including the random walk indicate that fundamentals can help at short horizons but less so at longer horizons.

Covered interest parity and arbitrage paradox in emerging markets: Evidence from the Korean market

While emerging forward exchange markets (EMs) have been rapidly developed, market efficiency has rarely been examined for EMs. To properly test the market efficiency for EMs, we set up a simple model to account for EM-specific realistic features. Based on the new model, we develop a modified covered interest parity (CIP) condition, which features multiple neutral bands associated with both transaction costs and differential borrowing costs. In addition, we apply the notion of ‘arbitrage paradox’ to test market efficiency. In particular, we focus not only on the violation event of the (modified) CIP condition but also on the persistence of arbitrage opportunities. We then apply this methodology to the Korean forward exchange market and provide empirical results for the Korean market, which can also be useful for analyzing other EMs.

Interactions between CNY and CNH Money and Forward Exchange Markets

We analysed the interactions between the RMB deliverable forward markets in Mainland China and Hong Kong. In order to broaden our perspective, we reference this to the Eurodollar market from the late 1950s to early 1980s. Our findings suggest that onshore regulations, notably the Regulation Q interest rate ceiling, were effective in containing spillovers between the Eurodollar market and the US domestic market. For the CNH market, we found evidence that cross-market spillovers between the Mainland and CNH markets became two-way in 2013, but were more limited and mostly not significant in earlier years. It was found that onshore-to-offshore spillovers were larger than spillovers in the opposite direction in most cases. This probably reflects the fact that the CNH market, though rapidly growing, is small compared to the Mainland market, and possibly more subject to onshore influences. Looking ahead, the Mainland market is expected to continue to play a leading role in onshore-offshore money and foreign exchange market interactions since these markets will be ultimately dominated by the monetary policy stance of the onshore authorities.

Regulation of Financial Market in Poland

Central banks analyze financial markets, because the initial impulses of the monetary policy go through them, before they reach the real economy. The effectiveness of monetary policy depends, to a large extent, on the degree of the development of financial markets. Financial markets have been developing in Poland since the beginning of the 1990. The first to develop was the inter-bank deposit market, which enabled banks to manage their liquidity. The next to develop was the Treasury bill market, which enabled the government to fund budget deficits. The introduction of partial convertibility of the zloty resulted in the emergence of the foreign exchange market in the early 1990. The stock exchange was developing simultaneously with the inter-bank markets, mainly as a result of privatization. The introduction of the trading band for the Polish zloty was a stimulus for the emergence of the forward foreign exchange market, which enabled hedging against the exchange rate risk. Gradually, the foreign exchange options market developed.

The role of heterogeneous expectations in forward exchange market

We build a Markov regime switching model to examine the role of heterogeneous expectations in the forward exchange market, where the regime could be fundamentalists or chartists. Our empirical analysis of EUR/USD and USD/JPY forward markets suggest that the fundamen-talists who follow negative feedback rule provide a mean-reverting dynamics into the market, while the chartists who follow positive feedback rule would reinforce the forward exchange rate movement. Finally, we find the chartists tend to switch to fundamentalists when the forward rate deviates away from its equilibrium.

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Price Transmission and Effects of Exchange Rates on Domestic Commodity Prices Via Offshore Hedging

The framework presents how trading in the foreign commodity futures and domestic forward foreign exchange markets can affect the optimal spot positions of domestic commodity producers and traders. It generalizes the models of Kawai and Zilcha (1986) and Kofman and Viaene (1991) to allow both intermediate and final commodities to be traded in the international and futures markets, and the exporter to face production shock, domestic factor costs and a random price. Applying the mean-variance expected utility, we find that a rise in exchange rate volatility can reduce both supply and demand for commodities and increase the domestic prices if the exchange rate elasticity of supply is greater than that of demand. Even though the forward foreign exchange market is unbiased, and there is no correlation between commodity prices and exchange rates, the exchange rate can affect domestic trading and prices through offshore hedging and international trade if the traders are interested in their profit in domestic currency. It illustrates how the world prices and foreign futures prices of commodities and their volatility can be transmitted to the domestic market as well as the dynamic relationship between intermediate and final goods prices. The equilibrium prices reflect trader behaviour i.e. who trade or do not trade in the foreign commodity futures and domestic forward currency markets. The empirical result applying a two-stage-least square approach and Thai rice and rubber prices supports the theoretical result.

THE GLOBAL CREDIT CRISIS AND CHINA'S EXCHANGE RATE

The case for stabilizing China's exchange rate against the dollar is strong. Before 2005 when the yuan/dollar rate was credibly fixed, it helped anchor China's domestic price level. But gradual RMB appreciation from July 2005 to July 2008 created a "one-way-bet" that disordered China's financial markets in two respects: (i) no private capital outflows to finance China's huge trade surplus leading to an undue build up of official exchange reserves and erosion of monetary control, and (ii) a breakdown of the forward exchange market in 2007–2008 so that exporters could no longer get trade credit — probably worsening the severe slump in Chinese exports. But after July 2008, the credit crunch induced an unexpected unwinding of the dollar carry trade leading to a sharp appreciation in the dollar's effective exchange rate. The People's Bank of China (PBC) then stopped RMB appreciation against the dollar. China's forward exchange market was restored and monetary control regained. Now the PBC can better support the fiscal stimulus by promoting a parallel expansion of bank credit. But, since March 2009, the fall in the dollar (with the RMB tied to it) again threatens to undermine the yuan/dollar rate and China's monetary stability.

Testing the hypothesis of market efficiency in the Taiwan-US forward exchange market since 1990

This article examines the applicability of the hypothesis of market efficiency in Taiwan's foreign exchange market using daily data. Instead of linear regression-based models, we consider the possibility that the true data generating process may come from two different distributions, and we employ the Markov Switching approach to analyse this. From the results of the two-state Markov Switching model, we define State 1 as the efficient state and State 2 as the inefficient one. Only the 30-day forward rate is able to differentiate between the two states. Based on the unconditional probabilities from the Markov switching model, we also find that the 30-day forward rate has a 70% probability in the efficient state, which indicates that 70% of all speculators fully extract information when predicting future spot rates, while 30% of all investors do not.

Return and Volatility Spillovers in Hong Kong Financial Markets

This paper studies the return and volatility spillovers between the stock market, the Exchange Fund Notes market and the Hong Kong dollar forward exchange market. Based on a bivariate GARCH model that specifies exogenous influences in the conditional mean and variance equations, this study examines the source and magnitude of the return and volatility spillover between financial markets. The estimation results suggest that while the pattern of return spillover is not clear, there is some evidence of volatility transmissions between selected financial markets in Hong Kong. In terms of the economic impact, however, most of these spillovers are minimal. When financial markets are turbulent, the return spillover from the forward exchange market to the stock market and the volatility transmission from the forward exchange market to the Exchange Fund Notes market can be substantial. As such, close monitoring of the fluctuations in the forward exchange market is warranted.

Exchange Rate Risk Premiums in Hong Kong Dollar: A Signal-Extraction Approach

Forward exchange rates convey information about the risk premiums of the currency exposures of the investors. The extraction of these risk premiums provides market information for the expected future values of a currency, which may be useful for policymakers in their market surveillance and monitoring. This study utilises a state-space model and the Kalman-filtering technique to estimate risk premiums of Hong Kong dollar from the forward exchange market from 1996 to 2005. The estimated risk premiums of the 12-motnh forward contract were as high as 3.4% of the spot exchange rate during the Asian financial crisis in 1998. The study also finds that the risk premiums have reverted from a discount in late 2004 to close to zero in mid-2005, reflecting that the appreciation pressure on the Hong Kong dollar along with the speculation on the revaluation of the renminbi in early 2005 has subsided after the introduction of the three refinements to the operation of the Linked Exchange Rate system in May 2005 and the reform of the renminbi exchange rate regime in July 2005. The forward exchange rates, after taking the estimated risk premiums into account, do not have a good forecasting capability for the future spot exchange rates. Among the two financial factors that drive the risk premiums in the Hong Kong dollar forward rates, the renminbi non-deliverable forward rates appear to have a larger impact than the Aggregate Balance of the banking system. Nonetheless, both factors are important for monitoring the risk premiums of the Hong Kong dollar exchange rate.

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Liquidity in the forward exchange market

The forward foreign exchange market is modelled within the framework of a limited participation two-country model and then simulated using the artificial economy methodology. The new model improves on the standard two-country cash-in-advance model in a number of ways. It gets closer to the observed lack of autocorrelation in spot returns and it helps to explain the persistence in the forward discount. However, it cannot account for the relative volatilities of spot returns and the forward discount. Finally, the model goes some distance in explaining the forward discount bias puzzle but falls short of resolving it.

Adaptive estimation of cointegrated models: simulation evidence and an application to the forward exchange market

The paper reports simulation and empirical evidence on the finite-sample performance of adaptive estimators in cointegrated systems. Adaptive estimators are asymptotically efficient, even when the shape of the likelihood function is unknown. We consider two representations of cointegrated systems—triangular cointegrating regressions and error correction models. The motivation for and advantages of adaptive estimators in such systems are discussed and their construction is described. We report results from the estimation of a forward exchange market unbiasedness regression using the adaptive and competing estimators, and provide related Monte Carlo simulation evidence on the performance of the estimators. Copyright © 1999 John Wiley & Sons, Ltd.

Variance ratio testing of the Australian forward foreign exchange market

This paper explores variance ratio testing of the Australian forward foreign exchange market. Our results support autocorrelation in our first sample period (July 1985 to January 1990) but an absence of autocorrelation in our second sample period (February 1990 to September 1995). This is consistent with greater efficiency in the forward foreign exchange market post 1990. This is consistent with the ‘peso’ problem associated with Australia's foreign debt disappearing with the acceptance of the arguments of Pitchford (Economic Papers, 8, 1989) and Corden (Economic Papers, 10, 1991) that the foreign debt does not matter.

Day-of-week effects in tests of forward foreign exchange rate unbiasedness

The day of the week on which the forward rate is quoted and the day of the week on which the corresponding one-period ahead spot rate matched to the delivery date of the forward contract is quoted may play a systematic role in the empirical estimates of the coefficient on the forward premium in tests of forward foreign exchange rate unbiasedness. These ‘day-of-week’ effects are motivated from an inventory carrying cost argument as in Bessembinder (1994) and introduced into a simple model for forward foreign exchange market efficiency. Empirical results show that the point estimates are generally consistent with the hypotheses; however, large standard errors make discriminatory power weak and conclusions regarding the role of inventory carrying costs in the magnitude of the forward premium bias debatable. Copyright © 1999 John Wiley & Sons, Ltd.

Day-of-week effects in tests of forward foreign exchange rate unbiasedness

The day of the week on which the forward rate is quoted and the day of the week on which the corresponding one-period ahead spot rate matched to the delivery date of the forward contract is quoted may play a systematic role in the empirical estimates of the coefficient on the forward premium in tests of forward foreign exchange rate unbiasedness. These ‘day-of-week’ effects are motivated from an inventory carrying cost argument as in Bessembinder (1994) and introduced into a simple model for forward foreign exchange market efficiency. Empirical results show that the point estimates are generally consistent with the hypotheses; however, large standard errors make discriminatory power weak and conclusions regarding the role of inventory carrying costs in the magnitude of the forward premium bias debatable. Copyright © 1999 John Wiley & Sons, Ltd.

The Origins of the Eurodollar Market in London: 1955–1963

The Eurocurrency market is arguably the most dramatic financial innovation in the post-war period yet very little is known about its origins. This paper examines two facets of the Eurodollar market: why it happened and why London kept most of the business. Using archival evidence, this article reveals that Eurodollars were accumulated earlier than has hitherto been thought. This has important implications for how we interpret the factors prompting the innovation. High interest rates, self-regulation by banks, and changes in access to the forward exchange market combined in mid-1955 to encourage innovation by the Midland Bank. The major source of competitive advantage for London was the regulatory environment which combined tight money in the domestic economy with relative freedom in international finance.

Testing for foreign exchange market efficiency - a trivariate vector autoregressive approach

The speculative efficiency of the forward exchange market for the British pound, Canadian dollar, German mark, Japanese yen and Swiss franc is evaluated in this study. The conventional approach of selecting spot and one-forward exchange rates is extended towards spot and two-forward exchange rates to consider the interactions among exchange rates of different contracts of different maturities. The possible cointegration of three series forms an error correction mechanism. Thus Campbell and Shiller's (1987) bivariate vector autoregressive model is extended to a trivariate VAR (TVAR) based on the error correction mechanism. A Wald test (with and without considering heteroscedasticity) is finally performed to examine the validity of the cross-equation restrictions. The speculative efficient market is rejected for the forward exchange market for the five currencies under study.

Forward exchange market unbiasedness: the case of the Australian dollar since 1984

This paper implements a robust statistical approach to regression with non-stationary time series. The methods were recently developed in other work and are briefly exposited here. They allow us to perform regressions in levels with non-stationary time series data, they accommodate data distributions with heavy tails and they permit serial dependence and temporal heterogeneity of unknown form in the equation errors. With these features the methods are well suited to applications with frequently sampled exchange rate data, which generally display all of these empirical characteristics. Our application here is to daily data on spot and forward exchange rates between the Australian and US dollars over the period 1984–1991, following the deregulation of the Australian foreign exchange market. We find big differences between the robust and the non-robust regression outcomes and in the associated statistical tests of the hypothesis that the forward rate is an unbiased predictor of the future spot rate. The robust tests reject the unbiasedness hypothesis but still give the forward rate an important role as a predictor of the future spot rate.