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Copeland, Exchange Rates and International Finance, 4th edition
Pearson Education Limited 2006
Slide 12.14
12.3 Forward Market Efficiency
Suppose you think that future spot price is 10% higher in 1 year. You
can make profit by buying the currency forward and selling it at spot, in 1
year. When will the speculation stop?
The relationship between the forward and spot markets under the
assumptions of RE, adequate arbitrage funds, free movement of funds,
and negligible transactions costs:
(12.2)
which is efficient market equilibrium as the forward rate reflects
1. Publicly available information summarised in the RE, ;
2. Markets attitude to risk, as embodied in the risk premium, .
t t t
t
t
s E f + =
+
+
1
1
t
1 + t t
s E
Copeland, Exchange Rates and International Finance, 4th edition
Pearson Education Limited 2006
Slide 12.15
12.3 Market Efficiency (continued)
Rewrite Equation (12.2) by subtracting from both sides:
(12.3)
Equation (12.3) implies:
(12.4)
Alternatively, stepping back one period:
(12.4)
t t t t t t t
t
t
u s s E s f + = + =
+ + + +
+
1 1 1 1
1
] [
1 + t
s
1
1
1 +
+
+
=
t t
t
t t
u f s
t t
t
t t
u f s =
1 1
Copeland, Exchange Rates and International Finance, 4th edition
Pearson Education Limited 2006
Slide 12.16
12.4 Unbiasedness
When the forward market is efficient and investors are risk neutral, there
fore they require no risk premium to take risky transactions:
Forward rate = expectation of the spot rate at the time contract matures
Spot rate = forward rate set in the previous period, plus or minus a
random error
(12.5)
Rewriting (12.5) in terms of rate of depreciation:
(12.5)
t
t
t t
u f s =
1
t t
t
t t t
u s f s s =
) (
1 1 1
Copeland, Exchange Rates and International Finance, 4th edition
Pearson Education Limited 2006
Slide 12.17
12.5 Random Walk Model
Random walk
Change in time series from one period to next is purely random:
(12.6)
Alternatively:
(12.6)
where is completely random (no pattern over time).
Random walk model outperform sophisticated model using fundamental
variablestodays exchange rate as the best guess of tomorrows.
t t t
u X X + =
1
t t t t
u X X X = A =
1
t
X
t
u
Copeland, Exchange Rates and International Finance, 4th edition
Pearson Education Limited 2006
Slide 12.18
12.5 Random walk model (continued)
Random walk with drift d
Change in time series from one period to next is equal to drift factor
plus purely random component:
(12.7)
Alternatively:
(12.7)
where is completely random (no pattern over time).
t t t
u d X X + + =
1
t t t t
u d X X X + = A =
1
t
X
t
u
Copeland, Exchange Rates and International Finance, 4th edition
Pearson Education Limited 2006
Slide 12.19
12.5 Market Efficiency and the Random Walk Model
1. The random walk model is compatible with RE, efficiency and
unbiasedness.
2. However, efficiency does NOT require that the spot rate
follow a random walk. Deviation from a random walk may be
due to a risk premium or a nonzero expected return
(depreciation).
t t t t
u s s + + =
+
1
The first term on the RHS could be explained by a risk
premium (possibly nonconstant). Even in the absence of a
risk premium (i.e. risk-neutrality), we could well have (s
t+1
s
t
)>0 if there is long run anticipated depreciation
compensated by the interest rate differential.
Copeland, Exchange Rates and International Finance, 4th edition
Pearson Education Limited 2006
Slide 12.20
12.5 Random Walk Model (continued)
If spot rate follows a RW with drift:
(12.8)
Taking expectations in (12.8) conditional on
(12.9)
(Note E
t-1
u
t
= E
t
u
t+1
=0 because the residual is zero-mean by definition,
and E
t-1
s
t-1
= E(s
t-1
| I
t-1
)=s
t-1
because s
t-1
is in I
t-1
t t t
u d s s + + =
1
d s u E d E s E s E
t t t t t t t t
+ = + + =
1 1 1 1 1 1
Copeland, Exchange Rates and International Finance, 4th edition
Pearson Education Limited 2006
Slide 12.21
12.5 Random Walk Model (continued)
If spot rate does not follow a RW with drift: for example,
(12.10)
RE forecast of the next periods spot rate:
(12.11)
Forward market efficiency for a RW:
(12.12)
Subtracting equation (12.11) from (12.10):
(12.13)
Profit made by a speculator paying the rationally expected spot rate at
time t 1 and selling on the spot in the next periodon average zero.
t t t t t t
u Z Z s s s + + + + =
1 2 1
o | o
1 1 2 1 1
+ + + =
t t t t t t t
Z Z E s s s E o | o
t t
t
t
s f + =
+1
t t t t t t t
u Z E Z s E s + =
) (
1 1
Copeland, Exchange Rates and International Finance, 4th edition
Pearson Education Limited 2006
Slide 12.22
12.8 Results
To test for unbiasedness, fit equations of the following
form:
(12.15)
1. estimate of the intercept a
- insignificantly different from zero?
2. estimate of the slope coefficient b
- insignificantly different from unity?
3. serially uncorrelated?
t
t
t t
v bf a s + + =
1
t
v
Copeland, Exchange Rates and International Finance, 4th edition
Pearson Education Limited 2006
Slide 12.23
When market sentiment
changes it results in a
change of direction in both
spot and forward rates
simultaneously
Sudden wave of bullishness about the
pound pushes up both the spot price of
sterling and its price for 30-day delivery
Spot rate against the lagged one-month forward rate
Copeland, Exchange Rates and International Finance, 4th edition
Pearson Education Limited 2006
Slide 12.24
Change in spot rate and the lagged forward premium
The premium is not only invariably smaller in
absolute terms, it is also far less volatile
Copeland, Exchange Rates and International Finance, 4th edition
Pearson Education Limited 2006
Slide 12.25
12.8 Results (continued)
If RE is assumed, then UIRP implies:
(12.16)
Since by definition:
Then a test of RE + UIRP would involve testing:
(12.17)
Alternatively, if we have direct (survey) information on expectations, we
can test:
(12.18)
*
1 1 1 t t t t t t t
e
t
r r s s E s E s = = A = A
+ + +
t t t t t
u r r s s + =
+
*
1
1 1 + +
+ =
t t
e
t
v s s
t t t t
u s s E + =
+ + 1 1
Copeland, Exchange Rates and International Finance, 4th edition
Pearson Education Limited 2006
Slide 12.26
Another topics?
1. Peso problem
A perennial discount (i.e. high money market rate) on
a currency which is officially pegged to the U.S. dollar or some
other reference currency. The discount exists because the market
perceives a small immediate probability of a large devaluation.
1955-76 Mexican peso was pegged against USD.
2. Excess volatility
The foreign exchange market "overreacts to eventsprove that
the foreign exchange market is sending confusing signals to
traders and investors who base their decisions on exchange rates.
Exchange rate should be volatile however are substantially more
volatile than the underlying factors that move them.