Forward Exchange Market Research Articles

The Behaviour of the Australian Forward Exchange Market

The efficiency of the Australian official forward exchange market is tested for the period September 1974 to June 1981. The results indicate that while the 90-days US dollar forward rate was an unbiased predictor of the future spot rate for the period as a whole, substantial differences between the two rates have been evident over prolonged short-run periods. Such evidence raises some important policy questions about the existing arrangements in the forward exchange market.

The Behavior of an Open-Economy Firm under Flexible Exchange Rates

Most proponents and opponents of floating believe that greater variability of foreign exchange rates will increase uncertainty in international transactions and, hence, that the volume of international trade and financial flows will be curtailed without well-developed facilities for hedging against exchange uncertainty. The effects of exchange risk on merchant exporters and importers have been studied by some authors under the assumption of fixed production (Ethier, 1973; Clark, 1973; Hodder, 1977; etc.). Others have investigated the production behaviour of an export firm in a static context (see, for example, Baron, 1976a, b). However, the impact of the greater volatility of exchange rates upon domestic employment and capital accumulation on the one hand and upon international financial transactions on the other has received scant attention in the literature. This paper establishes a dynamic model of a small, competitive firm which is engaged in domestic production, foreign trade (through exports of its products and/or imports of its inputs), and financial transactions in domestic and foreign currencies. Since the firm faces uncertainty about future exchange rates and future prices of outputs and inputs, it attempts to hedge against the risk if it is risk-averse. A forward foreign exchange market is assumed to exist. The firm's decisions on production, investment, forward contracting and financing, which are closely related in the model, are based on exogenously given probability distributions of exchange rates and prices. The paper is planned as follows. Section I presents a model of the firm and formulates its objective function and constraints. Section II solves its maximization problem and interprets the first-order conditions for short-run equilibrium. In particular, three different roles of the firm in the forward exchange or financial market are emphasized: pure hedging, speculative hedging and pure speculation. Section III analyses the dynamic behaviour of a typical open-economy firm. Section IV conducts comparative dynamic exercises of the firm in a long-run steady state equilibrium, and discusses how exchange rate uncertainty affects the firm's optimal decisions. The implications of the purchasing power parity condition are also developed. Section V summarizes our conclusions.

Inter-market efficiency and the foreign exchange market

This paper extends previous tests of weak-form efficiency in foreign exchange markets by (a) testing the efficiency of trades involving a combination of forward markets, and by (b) using data with a daily frequency. We show the Canada-U.S. forward exchange market to be weak-form efficient during the period 1972 to 1975 inclusive.

Three Roles of the Forward Foreign Exchange Market

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.

Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis

This paper examines the hypothesis that the expected rate of return to speculation in the forward foreign exchange market is zero; that is, the logarithm of the forward exchange rate is the market's conditional expectation of the logarithm of the future spot rate. A new computationally tractable econometric methodology for examining restrictions on a k-step-ahead forecasting equation is employed. Using data sampled more finely than the forecast interval, we are able to reject the simple market efficiency hypothesis for exchange rates from the 1970s and the 1920s. For the modern experience, the tests are also inconsistent with several alternative hypotheses which typically characterize the relationship between spot and forward exchange rates.

The South African forward exchange market

The South African forward exchange market

Tests of Rational Expectations in the Forward Exchange Market

This paper presents tests of the hypothesis that, during the current period of floating exchange rates, the forward rate has been equal to the expected future spot rate. These are tests of rational expectations if there are no transactions costs or risk premia. Progressively broader definitions of the information set (upon which expectations are conditional) are taken. When the sample period is started in mid-1974, rather than in early 1973, the deutsche mark passes all tests. Other currencies, such as the seth thpound, fail one or more tests. A statistical rationale for this finding, involving the possibility of discontinuously large errors, is suggested.

The ‘peso problem’ in testing the efficiency of forward exchange markets

In this paper we argue that when there is small probability of an event which would cause a large change in an exchange rate, the standard tests for the efficiency of the corresponding forward exchange market are not always valid. The mark pound forward market during the German hyperinflation is cited as an example. Using data from that hyperinflation, we show that an alternative test can sometimes be constructed in cases where the usual tests are not valid. The results reverse the conclusion of earlier researchers that the mark pound forward market during the hyperinflation was not efficient.

Speculation and the Forward Foreign Exchange Rate: A Note

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

Testing for the Role of Speculation in the Forward Exchange Market: A Reply

The issues raised by Steven Kohlhagen (1979) are interesting and merit careful consideration. I believe that such consideration leads to the conclusion that one of the problems that he describes is illusory but that the other is of wider applicability than his paper indicates. Before turning to these problems, however, I would like to point out that much of Kohlhagen's discussion proceeds under the presumption that of the future spot rate are incorrectly modelled-in my study (McCallum, 1977) or in others. But his analysis provides no particular justification for that presumption: the existence of expectations does not imply that are formed in any specific manner.I Consequently, this part of his discussion amounts to a reiteration of the fact that estimation of misspecified models is likely to produce misleading results. Since there is no dispute on that point, this aspect of Kohlhagen's discussion will henceforth be ignored. The interesting issues at hand concern estimation of the MT (modern theory) forward rate equationwith correctly modelled-when two particular conditions prevail. The conditions in question are as follows: (a) expected changes in spot exchange rates are related to expected inflation rates according to purchasing-power-parity considerations; (b) real interest rates are equalized across countries. Together (a) and (b) provide the case that Kohlhagen terms purely Fisherian expectations. In addition, he considers the case in which (a) holds but (b) does not. For reference, let us write the MT equation as2

Testing for the Role of Speculation in the Forward Exchange Market: Some Problems if There are Fisherian Expectations

Tests of so-called modern theory of foreign exchange market (MT) have differed over relative importance of interest arbitrage and speculation in forward exchange rate determination. For Canadian-U.S. foreign exchange market, whereas Kesselman (1971) and Haas (1974) found speculative demand schedule to have approximately same slope as arbitrage schedule, in a recent article in this REVIEW, McCallum's (1977) results using a expectations approach supported Stoll (1968). He stated that the supply of arbitrage is highly elastic, relative to supply of speculative funds (McCallum, 1977, p. 150).1 In this note we point out that to extent domestic financial markets and thus foreign exchange markets reflect Fisherian expectations about price changes and exchange rate changes, attempts to test so-called modern theory of foreign exchange market have been misinterpreted and also may have been misspecified. In fact, with purely Fisherian expectations, MT is empirically unidentifiable and thus impossible to test. The MT expresses forward premium as a weighted average of interest-parity forward premium and expected change in spot rate. Problems in estimating MT have primarily centered around what to use as a representation of expected spot rate (often referred to as unobservable2): Stoll (1968) used an adaptive expectations, weighted average of past spot rates while Kesselman (1971) and Haas (1974) used dual mechanistic weighted averages of past spot rates, incorporating both extrapolative and regressive elements (Kesselman also incorporated some real world variables). McCallum (1977) alternatively uses rational expectations in sense of Muth (1961). He uses actual spot rate in existence at maturity of forward contract as a proxy for expectations that are formed rationally, treating subsequent spot rate as an endogenous variable by utilizing a two-stage estimation technique with exogenous variables of system and lagged spot rates used as instruments in first stage. The possibility of existence of Fisherian exchange rate expectations has been derived from a Fisherian model of relationships between real and nominal interest rates in domestic financial markets and has been outlined in Aliber (1975), Giddy (1976), Kohlhagen (1978), Pippenger (1972), Porter (1971), Willett (1970, 1972), and Willett, Katz, and Branson (1970). In such a model (adopting McCallum's (1977) notation and three-period maturity framework), nominal interest rates in United States (iut) and Canada (ict) are equal to real rates (rut and rct, respectively) plus expected rate of change of prices (1TeUt and 7TeCt, respectively):

Underutilization of Forward Markets or Rational Behavior?

THE POSSIBILITY OF EMPLOYING the forward exchange market in order to avoid risk resulting from exchange rate variations is so well known that it might seem surprising that many positions in foreign currency denominated instruments go unhedged. One possible reason for failing to obtain forward cover stems from the transactions costs that are involved.' Another reason is the conscious decision of speculators who keep open positions based on the difference between their expectation of future spot rates and corresponding forward rates.2 In addition, many writers have emphasized that there are alternative ways by which positions in certain currencies might be offset. For example, foreign currency receivables can be offset by denominating borrowing in that same currency. In other words, asset and liability positions can be cancelling within particular individual currencies without resorting to forward markets.3 This paper suggests a further possible reason why many foreign exchange positions are not covered in the forward market. In particular it is shown that in a world where cross-elasticities between foreign currency movements are known, a portfolio that involves positions in k currencies can theoretically be completely hedged against variations in any of these k currency values with only one forward contract. The hedged portfolio will in general involve open positions in every currency and utilize only the single forward contract.4

Testing for Rational Expectations in Foreign Exchange Markets

The rational expectations hypothesis implies that if investors are risk neutral (and if transactions costs are zero), the current price for foreign exchange for future delivery -- the forward price -- will be unbiased predictor of the actual spot price at the time the forward contract matures. This proposition is conventionally tested by regressing the level of the current spot price on the level of the lagged forward price. This note proposes as alternative test, in which the chagne in the spot price, or rate of depreciation, is regressed on the forward discount rate. In general the two tests yield different results; it is further argued that the alternative test provides additional insight into the behavior of the forward exchange market. The two test equations are estimated for several exchange markets, and the alternative test is shown to reject rational expectations in a case where the conventional test does not.

The Case for a Forward Exchange Market in South Africa R. M. Gidlow1

South African Journal of EconomicsVolume 47, Issue 1 p. 24-37 The Case for a Forward Exchange Market in South Africa R. M. Gidlow1 First published: March 1979 https://doi.org/10.1111/j.1813-6982.1979.tb00593.x 1 Senior Lecturer, Department of Business Economics, University of the Witwatersrand. AboutPDF ToolsRequest permissionExport citationAdd to favoritesTrack citation ShareShare Give accessShare full text accessShare full-text accessPlease review our Terms and Conditions of Use and check box below to share full-text version of article.I have read and accept the Wiley Online Library Terms and Conditions of UseShareable LinkUse the link below to share a full-text version of this article with your friends and colleagues. Learn more.Copy URL Share a linkShare onFacebookTwitterLinkedInRedditWechat Volume47, Issue1March 1979Pages 24-37 RelatedInformation

The Return of the Profit Rate to the Wage Equation

McCallum, Bennett T., The Role of Speculation in the Canadian Forward Exchange Market: Some Estimates Assuming Rational Expectations, this REVIEW 59 (May 1977) 145-151. Officer, Lawrence H., and Thomas D. Willet, The Covered Arbitrage Schedule: A Critical Study of Recent Developments, Journal of Money, Credit and Banking 2 (May 1970) 247-257. Stoll, Hans B., An Empirical Study of the Forward Exchange Market under Fixed and Flexible Exchange Rate Systems, Canadian Journal of Economics 1 (Feb. 1968), 55-78.

Optimal Foreign Borrowing Strategies with Operations in Forward Exchange Markets

Optimal Foreign Borrowing Strategies with Operations in Forward Exchange Markets

Abstract: An Examination of the Forward Exchange Market during Pegged and Floating Systems: United States, Canada, Germany, and United Kingdom

This paper examines the profitability and risk of a naive strategy of forward exchange speculation during pegged and flexible exchange rate systems. It suggests a new method of calculating these speculative returns and shows that the average return was much less than previously supposed and that the distribution of returns differed between systems and countries.

A multiperiod theory of forward exchange

The purpose of this paper is to extend the theory of forward exchange developed by S.C. Tsiang and Egon Sohmen by adding to it an important relationship between the speculative demands for foreign exchange. With this extended theory of forward exchange it is relatively easy to clearly and carefully analyze complex problems involving the interaction of spot and forward markets in different time periods. To illustrate this point the theory is used to analyze the same problem that Tsiang attacked unsuccessfully – determining the deferred effect of government intervention in the forward exchange market.

The Role of Speculation in the Canadian Forward Exchange Market: Some Estimates Assuming Rational Expectations

M AINLY in order to ascertain the importance of speculative influences in the determination of forward exchange rates, Stoll (1968), Kesselman (1971), and Haas (1974) have obtained estimates of the modern theory equilibrium condition that expresses the forward rate as a weighted average of the interest-parity forward rate and the expected spot rate.' While these authors have used different representations for the (unobservable) expected spot rate, all have relied upon distributed-lag formulations of one type or another.2 Recently, however, several economists have argued rather convincingly that there are serious weaknesses inherent in the distributed-lag approach-see, e.g., Gordon and Hynes (1970), Lucas (1972), Sargent (1973), and Rutledge (1974). It would be preferable, these authors have suggested, to adopt the rational expectations hypothesis of J. F. Muth, which asserts that ...expectations, since they are informed predictions of future events, are essentially the same as the predictions of the relevant economic theory.3 The purpose of the present paper is, accordingly, to report estimates of the modern-theory equation obtained under the assumption that expectations are in fact formed rationally. Our analysis also differs from that of Stoll, Kesselman, and Haas in an additional way: Whereas each of these writers assumed (implicitly) that the current spot rate can be viewed as an exogenous, or at least predetermined, variable, our treatment recognizes that spot and forward rates are determined simultaneously.4 Our data, on the other hand, are much the same as those used in the earlier papers. Thus the Canadian-U.S. rate is studied for the same 1953-60 period as was considered by Kesselman and Haas. Our estimation techniquewhich will be outlined belowhas been used previously by Sargent (1973) and McCallum (1976); it is discussed in some detail in the second of these papers.

Euro-Dollars, Capital Mobility and the Forward Exchange Market

Economists have long recognized that the Euro-dollar market plays an important role in the mechanism by which monetary disturbances are transmitted among countries. Nevertheless, little is known about either the portfolio behaviour that gives rise to the mechanism, or the speed with which monetary changes originating in one country are transmitted internationally. The present study attempts to furnish some tentative answers to these questions. While there is now a growing literature on the subject of Euro-currencies (Black, 1971; Bryant and Hendershott, 1970; Freedman, 1973; Hendershott, 1967; Levin, 1974; Rich, 1972), most studies employ equilibrium models of portfolio selection in which forward exchange premiums are taken as given, thus excluding the problems of disequilibrium adjustment and forward market behaviour which are considered here. Although this paper analyses a single international asset market, the estimation results have broader significance as well. In particular, they bear upon two fundamental questions of international finance: the degree of international capital mobility, and the determinants of the forward exchange rate. Both of these topics have implications for the theory of the balance of payments. In order better to understand the balance of payments adjustment mechanism, it is important to obtain empirical estimates of both the degree of capital mobility and the behaviour of the forward exchange market. Capital mobility has two aspects: the substitutability of assets and the speed of international portfolio adjustment. For capital mobility to be high, assets denominated in different currencies must be close substitutes in the portfolios of the economic agents that transact in international financial markets. In addition, these sectors must be able to adjust their multicurrency portfolios rapidly in response to change. Moreover, the level of the forward exchange rate may depend both on the existence of lagged adjustment and on factors that affect speculators' expectations about the future spot rate. To investigate these questions it is necessary to specify a simultaneous dynamic model of international financial behaviour in which asset-substitution effects, expectations and the time lags of portfolio adjustment can actually be measured empirically. Such a model is constructed and estimated in this paper.