Future Spot Rates Research Articles

The information in the Mexican term structure of interest rates: capital market implications

Abstract This paper employs the term structure approach to examine Mexican security markets during the recent period of political and economic turmoil. We investigate the characteristics of these markets and the forecast applicability of the pure expectations hypothesis to interest rates in Mexico. We find that both forward rates and spot rate spreads are found to have significant forecasting ability for future spot rates for Mexico. Both forecasting approaches suggest greater predictive ability during the period of higher interest rates and general economic volatility (1995–1996) than the more stable economic environment of the early 1990s (1991–1994).

The Value of Invoice Currency Choice in a Volatile Exchange Rate Environment

The paper explores the conditions whereby an exporter can gain a competitive advantage by offering a buyer a contract with a choice of invoice currencies rather than a single currency, and determines the value of such a choice. The model incorporates accounts-payable management with exchange- risk management, taking into account the forward exchange rate and the seller's assumptions about the buyer's initial foreign exchange position, its expectations about the future spot rate, and its risk premium. It demonstrates how the value of a choice depends on these variables, as well as on the market interest rates in the two currencies, and on the implicit conversion factor that the seller uses in pricing in different currencies.

The forward bias: is it a money tree?

This paper examines the forward discount anomaly, i.e. the fact that the forward exchange rate is a biased predictor of the future spot rate. We run a series of rolling regressions which we use to predict the value of the future spot rate based upon this bias. We show that the average return from an investment strategy based on the bias in forward exchange rates is in many cases insignificantly different from zero. In other cases, however, the return is significantly positive. Hence the in-sample bias does not necessarily lead to a money-making strategy for all currencies.

Spot and forward exchange rates as predictors of future spot rates: trends in exchange market value and the contribution of new information

This study investigates whether or not new information affects the predictive capability of forward and spot foreign exchange rates symmetrically during periods of rising as opposed to falling currency values. Statistically significant different intercept and slope coefficients are found between the periods of U.S. dollar appreciation and U.S. dollar depreciation. Further, the predictive ability of the two models differs between opposite trends in foreign exchange values.

Common stochastic trends between forward and spot exchange rates

The common trend analyses between the forward rate ( F t ) and the corresponding future spot rate of the same currency ( S t+1 ) have raised several issues: notably, the sensitivity of the cointegrating relation to a constant term and lag lengths and the non-stationarity of the risk premium. This paper addresses these issues more rigorously using the daily exchange rate of the pound Sterling vis-à-vis five major currencies viz. the Canadian dollar, French franc, German mark, Japanese yen, and US dollar. The appropriate deterministic term in the cointegrating space is identified through empirical tests. A robust cointegrating relation is found between F t and S t+1 ; however, the hypothesis of unbiasedness of forward rate could not be sustained. An alternative measure of risk premium is suggested and its stationarity is confirmed.

Random walks in the U.K. pound/ U.S. dollar exchange rates

Since the adoption of flexible exchange rates in the early 1970s, tests of foreign exchange rate efficiency have abounded and can be categorized into three main approaches. The first approach is to examine exchange rates in an arbitrage context to determine if they are out of parity with interest rates or other exchange rates. The second approach to efficiency testing concerns the ability of forward exchange rates to predict corresponding future spot rates. The third approach to exchange rate efficiency testing is to examine exchange rates as a time series to determine whether or not they follow a random walk. This paper follows the third approach to exchange rate efficiency testing. Efficiency testing of exchange rates under the null hypothesis of the random walk is a natural progression in the research of exchange rate determination. This paper shows that the random walk hypothesis is not rejected for the £/$ annual real exchange rate. Although the £/$ annual real exchange rate has mean reverting tendencies due to PPP, frequent and strong shocks to the nominal exchange rate assure that the series follows a random walk since these shocks directly influence real exchange rates. The random walk hypothesis is also not rejected for the £/$ monthly nominal exchange rate, making profitable trading schemes between the currencies unlikely. Both conclusions are consistent in that a random walk in nominal exchange rates should lead to a random walk in real exchange rates.

Two puzzles in the analysis of foreign exchange market efficiency

Based on our analysis of three data sets, we explore two puzzles in the literature on foreign exchange market efficiency. First, it appears that while excess returns are stationary, the forward premium could be generated by a time series process that is integrated of order one: this is theoretically impossible. Second, regressions of the future change in the spot rate on the forward premium very often generate negative estimated slopes. The implication that the forward rate has perverse merit in the prediction of future spot rates is paradoxical. We show how the first puzzle can be resolved through the properties of a simple bivariate time series model that is compatible with our data sets. The second puzzle vanishes when forecasts are corrected for autocorrelated errors.

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.

Adjusted Forward Rates as Predictors of Future Spot Rates

Prior studies indicate that the predictive power of implied forward rates for future spot rates is weak over long sample periods and typically varies dramatically across different subperiods. Fama (1976, 1984) conjectures that the low forecast power is due to a failure to control for the term premium embedded in forward rates. We show that Fama's conjecture is consistent with the data using any of four different models of the term premium. We measure the term premium using a variety of ex ante instruments, including the junk bond premium,bid-ask spreads in Treasury bills, the Standard & Poor's 500 stock index's dividend yield and the conditional volatility of interest rate changes using an Autoregressive Conditionally Heteroscedastic (ARCH) process. Forward rates adjusted for the term premium are reliable predictors of future spot rates over the entire 1963-1993 period.

Understanding spot and forward exchange rate regressions

SUMMARY Using the Kalman filter, we obtain maximum likelihood estimates of a permanent‐transitory components model for log spot and forward dollar prices of the pound, the franc, and the yen. This simple parametric model is useful in understanding why the forward rate may be an unbiased predictor of the future spot rate even though an increase in the forward premium predicts a dollar appreciation. Our estimates of the expected excess return on short-term dollar-denominated assets are persistent and reasonable in magnitude. They also exhibit sign fluctuations and negative covariance with the estimated expected depreciation. #1997 John Wiley & Sons, Ltd. J. Appl. Econ., 12, 715‐734 (1997)

Understanding spot and forward exchange rate regressions

Using the Kalman filter, we obtain maximum likelihood estimates of a permanent–transitory components model for log spot and forward dollar prices of the pound, the franc, and the yen. This simple parametric model is useful in understanding why the forward rate may be an unbiased predictor of the future spot rate even though an increase in the forward premium predicts a dollar appreciation. Our estimates of the expected excess return on short-term dollar-denominated assets are persistent and reasonable in magnitude. They also exhibit sign fluctuations and negative covariance with the estimated expected depreciation. © 1997 John Wiley & Sons, Ltd.

Macroeconomic uncertainty and the risk premium in the foreign exchange market

In modeling the risk premium in the foreign exchange market, I assume that money and production follow a joint stochastic process with bivariate GARCH innovations. My formulation is based on Lucas' asset pricing model and implies that the risk premium in the foreign exchange market is due to time-varying volatilities in macroeconomic variables. Testing the model for three currencies shows the time-varying risk premium to be significant in explaining the deviation of the forward foreign exchange rate from the future spot rate. Diagnostic testing of the model partially supports the market efficiency hypothesis after accounting for the time-varying risk premium. (JEL F31). © 1997 Elsevier Science Ltd.

On the unbiasedness of the forward rate in the Singapore foreign exchange market

This paper evaluates the extent to which the forward exchange rate serves as an ‘unbiased’ predictor of the future spot rate, premised on a framework that is independent of the assumption of risk neutrality and rational expectation. The results show that daily Singapore Dollar/US Dollar spot and forward exchange rates are cointegrated and the estimated cointegrating vectors satisfy the unbiased forward rate hypothesis restriction.

The advantage to hiding one's hand: Speculation and central bank intervention in the foreign exchange market

Abstract We analyze an asymmetric information model of sterilized intervention in the foreign exchange market. We characterize an equilibrium in which a central bank with ‘inside information’ about its exchange rate target trades with risk averse speculators who have private information about future spot rates. The model identifies circumstances in which ‘perverse’ responses to intervention will be observed, i.e. the domestic currency depreciates when the central bank purchases it, and it provides conditions under which the exchange rate will be highly sensitive to intervention. The model also provides an explanation for two forms of ‘policy secrecy’: (i) secrecy about the scale of an intervention operation is always desirable, (ii) secrecy about the target is sometimes desirable.

Adjusted Forward Rates as Predictors of Future Spot Rates

Adjusted Forward Rates as Predictors of Future Spot Rates

Why Does the Spot-Forward Discount Fail to Predict Changes in Future Spot Rates?

We use the Phillips and Hansen (1990) modified procedure to estimate the cointegrating vector between Ft, the forward exchange rate, and St+1, the appropriate spot rate. We find that the coefficient β, from the equation, St+1 = α + βFt + et+1 to be very close to, but significantly different from, 1 (at about 0.97), as we had expected on theoretical grounds. With β≠1, running the equation St+1 − St = α + β(Ft − St) + ut will involve misspecification, which will bias the measured value of β towards 0. © 1997 John Wiley & Sons, Ltd.

A Bayesian approach to foreign exchange forecasting

This paper shows how the loss function approach of Bayesian statistics can be used to develop more useful forecasts in foreign exchange markets. These forecasts may be needed for a variety of applications such as speculation in forward markets, economic or accounting hedging, and estimating future costs or revenues. In the classical (i.e., mean squared error) method the same negative values are assigned to both positive and negative forecast errors, and, as a result, an unbiased forecast is seen as being optimal. The Bayesian approach proposed here, on the other hand, explicitly accounts for consequences of positive or negative forecast errors and for the possible presence of a bias in forward exchange rates. As a result, the optimal forecast is usually not equal to the conditional expected value of the future spot rate. The approach proposed here can be adopted regardless of the economic model used by forecasters. The International Fisher Effect is employed to illustrate how this paper's model can be used in practice and how its outcome may differ from the mean squared approach. The results show that for the sample period the forecasts based upon this paper's loss function slightly outperformed those based upon the mean squared errors approach.

A VARIANCE DECOMPOSITION ANALYSIS OF THE INFORMATION IN THE TERM STRUCTURE

AbstractBased on a market efficiency assumption, we use variance decomposition analysis to separate information in the term structure on expected future spot rates from information on time‐varying term premia and to examine the market's ability to forecast both future rate changes and excess returns on long versus short securities. We find that fluctuations in the slope of the yield curve are due more to changing term premia than to fluctuations in expected future spot rates and that the market correctly predicts about 40 percent of the month‐to‐month changes in spot rates, a considerably higher percentage than that found by previous studies.

Adjusted Forward Rates as Predictors of Future Spot Rates

Prior studies indicate that the predictive power of implied forward rates for future spot rates is weak over long sample periods and typically varies dramatically across different subperiods. Fama (1976, 1984) conjectures that the low forecast power is due to a failure to control for the term premium embedded in forward rates. We show that Fama’s conjecture is consistent with the data using any of four different models of the term premium. We measure the term premium using a variety of ex ante instruments, including the junk bond premium, bid-ask spreads in Treasury bills, the Standard & Poor’s 500 stock index’s dividend yield and the conditional volatility of interest rate changes using an Autoregressiv e Conditionally Heteroscedastic (ARCH) process. Forward rates adjusted for the term premium are reliable predictors of future spot rates over the entire 1963-1993 period.

Testing the unbiasedness hypothesis of foreign exchange rates and the analysis of transformations

Recent researchers have utilized various functional forms for testing the hypothesis that the forward rate is an unbiased predictor of future spot rates in foreign exchange markets. We compare a large number of these functional forms for a similar time period and test their consistency with the data for five major currencies. Our results imply that certain functional form models may be inappropriate for some currencies. Researchers must, therefore, be cautious of misspecification due to erroneous functional forms when testing the unbiased forward rate hypothesis.