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MSc in International Business

7BSP1091: International Finance Module Leader: Edward Kerr

Topic: Foreign Exchange Market Efficiency and Forward Rate Unbiased Predictor of Future Spot Rate Prepared by: Charles Coker 10250966


Table of Content 1.0 Introduction..3 2.0 Foreign Exchange Market Efficiency............ 4 2.1 Theory of Market efficiency4 3.0 Interest rates parity ..7 4.0 Unbiased Expectation Theory .7 5.0 International Fisher Effect ...9 6.0 Purchasing Power parity (PPP) and Empiricism 10 7.0 Conclusion.11 8.0 References..12



Over the past few years, the relationship between forward and spot rates in foreign exchange has been of significant interest to investors and policy makers. The relationship between these two elements continues to intrigue us; considering their importance from an economic perspective. There seems to be continuous deviations from efficiency and rationality even though there have been large trading volumes and low trading costs in currency markets. There has been consistent empirical evidence which shows that forward rates are efficient forecasts of future spot rates. This has been a significant matter which has had important economic and public policy implications. This report aims at analysing if foreign exchange markets are efficient; the report also seeks to examine if forward exchange rates are unbiased predictors of future spot rates. The report would be carried out using appropriate International finance theories such as the Market efficiency theory, Purchasing power parity theory, Unbiased Expectations Hypothesis, Interest rate parity theory and the International Fischer effect theory.




According to Buckley (2004), an efficient market is one in which security prices adjust rapidly to the infusion of new information and current stock prices fully reflect all available information including risks involved. Participants in the market cannot earn economic profits such as risk adjusted profits on the basis if available information when the market is efficient. Over time, scholars have had different viewpoints on how efficient the market really is, as reflected in the different versions of the efficient market hypothesis. Investors on the other hand believe that stocks can become undervalued due to several reasons which would lead to them being priced below what they are actually worth. When the market is perfectly competitive, the interplay of buyers and sellers leads to the market price being unique; where the marginal cost of supply equals marginal satisfaction obtained by buyers in the market. Supply costs are also minimized and as a result, market participants cannot gain without loss to another. Structural characteristics are emphasized by economic theory, and organizational aspects of the markets are often neglected. 2.1 The theory of market efficiency

According to Levich (1980), actual prices are expected to fully conform to their equilibrium values and actual returns are expected to fully conform to their equilibrium expected values in an efficient market. In other words, no arbitrage opportunities should exist in an efficient market. For example, if a Swiss investor thinks that the spot price for US dollars in terms of the Swiss franc will be 10% higher in 10 months time; considering that transaction costs are negligible, the investor will be able to make profit by buying dollars (selling the Swiss franc) forward, then selling the dollars spot after 12 months. If his judgement is right, his profit will be 10% less all transaction costs, less the premium paid for forward dollars. If other investors in the market with sufficient funds share this view, the situation would not continue. This is because the forward dollar would continue to be bid up which will result in a very high premium and any further speculation would be discouraged. In other words, speculation will continue until the forward exchange rate reaches a point where it will almost equal the future spot rate. At this point, investors will feel that the profits they would make would not be enough to compensate for the risks of being wrong in their speculation. This results in a cease in

speculation and equilibrium at the point where the difference between the forward rate and the markets expectation of future spot rates equals the required risk premium. Considering that the markets expectations are rational, the equilibrium can be written as follows:

Ft t+1=Etst+1 +pt =ut+1 +pt

The left hand side represents the forward price of dollars at time t for delivery one period later (at t+1), and pt represents the market risk premium. The above equation represents an efficient market equilibrium, this is because the forward rate reflects the publicly available information summarized in the rational expectation, Etst+1 and the market risk premium as evident in the risk premium. In other words, the market becomes efficient if on the average, expected errors equal zero, considering that the errors do not follow any pattern that could be taken advantage of in order to realize profits. Exchange rates are always changing and this is evident in Efficient market Hypothesis because new information always comes up in the market in different forms such as, the news, opinions, assumptions, etc. Due to the constant arrival of information in the market, prices are continuously adjusted as the efficient market hypothesis claims. According to Fama (1970) market efficiency can be classified into three categories which include: strong efficiency, semi-strong efficiency and weak efficiency. The weak form of efficiency states the current prices reflect all historic information. The semi-strong form of efficiency states that current prices reflect all publicly available information. Finally, the strong form of efficiency states that the current price of an asset reflects all available information including proprietary and insider information. According to Cornell and Dictrich (1978), evidence was found that the foreign exchange market is efficient, although the result of their research was only consistent with weak efficiency. An analysis of six different currencies during the period of 1920-1924 suggested that semi-

strong efficiency yields the most appropriate description for the pattern of exchange rate movement. The four way equivalence model was used by Buckley (2004) to explain the relationship between the spot exchange rate, forward exchange rate, future spot rate, interest rates and the inflation rate, mentioned in explaining market efficiency.

Table 2.1.

The four Way Equivalence in the foreign exchange market (Fisher Effect) Equal (IFE)
Difference in expected inflation * 1+ *

Difference in Interest Rate I I* 1+i*



Equal Expectation theory Equal

Equal (purchasing power parity)

Difference between spot & forward rate fo- So So

Expected change in Spot rate st - so so

(Buckley, 2004)


Interest Rate Parity

Interest parity holds when the interest rate differential between two countries is equal

to the differential between the forward exchange rate and the spot exchange rate. Interest rate parity plays an essential role in foreign exchange markets, connecting interest rates, spot exchange rates and foreign exchange rates (investopedia.com). This relationship is evident when the two methods an investor may employ in order to convert foreign currency into dollars are examined; investing the foreign currency locally at a risk free rate over a specific time period would be the first option. The investor then at the same time enters a forward rate agreement so as to convert the proceeds from the investment into US dollars with the use of a forward rate at the end of the investing period. The second option would be to convert the foreign currency into US dollars at the spot exchange rate. The investor then invests the dollars for the same time period as in the previous method at the local (US) risk free rate. When there is no existence of any arbitrage opportunities, the cash flows from both options are equal. Interest rate parity connects the forward rate to the spot rate and interest rates in the domestic economy to those abroad. (Sercu-Uppal, 1995) This relationship holds because the forward rate Ft ,T is known. Additionally, the forward rate is not affected by investors risk aversion or uncertainty. Interest rate parity is the strongest relationship, and through arbitrage it is used to ensure that financial prices reflect a forward premium predicted by interest rate parity. (Sercu-Uppal, 1995)


Unbiased Expectations Hypothesis

The unbiased expectations hypothesis is the theory that forward exchange rates are unbiased predictors of future spot rates. This hypothesis assumes that there is no uncertainty about inflation. The asset market approach when determining exchange rates view currencies as asset prices traded in an efficient financial market. The unbiased expectations hypothesis holds that, a rising term structure must indicate that inflation rate is expected to rise, and the market expects short-term rates to rise throughout the future. Similarly, a flat term structure reflects an expectation that future

short-term rates will remain relatively constant, while a falling term structure must reflect an expectation of decreasing rates of inflation and that future short-term rates will decline steadily. Upward /downward sloped yield curves show that short-term interest rates are expected to rise/fall in the future. the expectations theory also explains that long term rates are a geometric average of current short term rates (1 year rate now) and expected future short term rates (1 year rates in the future). A 2 year investment at R2 (spot, or nominal 2 year rate) should be equal to a series of 2 one-year investments at R1 now and f2 in one year (during Year 2), where f2 is the forward rate for year two, i.e. the expected one year interest rate during Year 2. A 3 year investment at R3 (spot, or nominal 3 year rate) should be equal to a series of 3 one-year investments at R1 now, f2 in one year (during Year 2), and f3 in two years (during Year 3). OR:

2 year time horizon: (1 + R2)2 = (1 + R1) (1 + f2) 3 year time horizon (1 + R3)3 = (1 + R1) (1 + f2) (1 + f3) or equivalently (1 + R3)3 = (1 + R2)2 (1 + f3) or for a 30 year period: (1 + R30)30 = (1 + R29)29 (1 + f30) (1 + Rn)n = (1 + Rn-1)n-1 (1 + fn) Forward rates (ft) are the expected one year spot (nominal) rates in year t. f2 = Expected One-Year Interest Rate during YR 2 f3 = Expected One-Year Interest Rate during YR 3


The International Fisher Effect

According to Buckley 2004, International fisher effect suggests that interest rate differentials will be equal to expected change in spot rates. The theory explains that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation.
i r r (1)
S1 S s x 100 i domestic i foreign . (2) S2

In equation 1 above, (i) is the nominal rate of interest, (r) is the real rate of interest, and () stands for the expected rate of inflation over the period the funds are to be lent. An approximation of the Fisher effect drops the final term. Equation 2 serves as an example of the International Fisher effect, where S1 stands for the spot rate at the beginning of the period and S2 stands for the spot rate at the end of the period; (i) represents the respective national interest rates. The International Fisher effect then states that the spot exchange rate should change in an amount equal to, but in the opposite direction of the difference in interest rates between two countries.


Purchasing Power Parity (PPP)

Purchasing power parity states that spot exchange rates are calculated considering the relative prices of a similar commodity; it holds that if the law of one price were to hold based on the assumption that market is free from barrier and transport cost, the price of identical commodity will be the same in all countries expressed in form of similar currencies (Buckley, 2004). In other words, Purchasing power parity (PPP) states that over the long-run the exchange rate between two currencies adjusts to relative price levels. The equation below explain that, the spot exchange rate at the end of the period (S1) over the spot exchange rate at the beginning of the period (S0) is equal to one plus the foreign inflation rate (1 + IF) over one plus the domestic inflation rate (1+ ID).
S1 1 I F (3) S 0 1 ID

PPP on the other hand holds that relative changes in the price between countries over a period of time will lead to the change in exchange rate; this will not affect the spot rate
(Eiteman, Stonehill & Moffett, 2007). This means that any changes in the rate of

inflation between the countries will be compensated by equal opposite change in the spot rate over a period of time when the starting spot rates between the countries are at equilibrium.




According to Krugman and Obstfeld (2003), asset prices respond immediately to changes in expectations and interest rates. The major characteristic of an efficient market is that the information available to market participants should be fully reflected by prices so that it will be impossible for the trader to earn excess return to speculation (Taylor & Sarno, 2003). As a result, any available arbitrage opportunity in the market will be cancelled out quickly due to the changes in supply and demand. In an efficient market, the forward rates, as with all derivatives products, are priced under the hypothesis of non-arbitrage opportunity. According to Levich, 2001, the Sources of market inefficiencies are uncertain--they can reflect speculation, insider trading, corruption, or poor decisions from central banks and governments. But what is certain is that they create challenges for decision makers. It remains doubtful whether or not the foreign exchange market is an efficient one; this is because only the historical is incorporated in prices and all other information are usually not considered. While the forward rate is a decent predictor of the future spot rate, it does not capture all information available to economic agents. This variance in exchange rates could be caused by news about economic factors such as changes in domestic and foreign quantities of money, real incomes, and real interest rates that were not available when the forward rate was first determined.




Buckley, A (2004) Multinational Finance, 5th edition, Prentice Hall Cornell, B and Dictrich, J. K (1978), The efficiency of the market for foreign exchange market under floating exchange rates. Review of economics & Statistics, 60 (1), 111-120 Definition of interest rate parity available at <http://www.investopedia.com/terms/i/interestrateparity.asp#axzz1s1Z7yAbo> Accessed 9 April 2012 Eiteman, David K., Stonehill, Arthur I., and Moffett, Michael H. (2001) Multinational Business Finance 9th edition, published by Addison-Wesley Longman, Inc. Fama, E. (1970), Efficient Capital Market: A review of Theory and Empirical Work, Journal of Finance, 25: 383-417 Fama, E. (1984), Forward and Spot Exchange Rates. Journal of Monetary Economics 34: 319-338 Iulia Stefan, 2009, testing the efficient markets hypothesis: a behavioural approach to the current economic crisis, available at <http://econ.berkeley.edu/sites/default/files/iulia_stefan_thesis.pdf> Accessed 10 April 2012 KRUGMAN, P.R. and OBSTFELD, M. (2003) International Economics: Theory and Policy, 6th Edition, Addison Wesley: Boston. Levich, Richard M. (2001) International Financial Markets, 2nd edition, published by McGraw-Hill. Levich, Richard M. oxford review of economic policy, vol. 5, no. 3 available at <http://oxrep.oxfordjournals.org/content/5/3/40.full.pdf>


Sercu, Piet and Uppal, Raman, (1995) International Financial Markets and the Firm, published by SouthWestern. TAYLOR, M.P. and SARNO, L (2003) The Economics of exchange rates, Cambridge: Cambridge University Press