City Research Online

Abstract

This study provides a new test of the hypothesis that speculative efficiency holds in the forward market for foreign exchange. Speculative efficiency is said to hold in the forward market if expectations are formed rationally and speculators are risk-neutral. The forward rate will then be an unbiased predictor of the future spot rate. Speculative efficiency has important implications for the theory of exchange rate determination, the conduct of
exchange rate policy and the management of exchange rate exposure. However, previous tests of the hypothesis have been inconclusive. This paper firstly provides a critical review of tests of the speculative efficiency hypothesis in the existing literature, secondly, derives new tests based on a more rigorous examination of forward market behaviour and, thirdly, presents the findings. Previous research has mostly concentrated on the statistical properties of the forward rate as a predictor of the future spot rate. There has been little attempt to explicitly model forward market behaviour. The first part of this study reviews the theory of forward rate determination within a partial equilibrium setting. Building on this, the joint determination of spot and forward exchange rates within a general equilibrium framework is considered. The original contribution of this study is then to examine the adjustment paths of spot and forward exchange rates under alternative assumptions about risk-averse behaviour in the forward market. Model simulations demonstrate that, following a monetary disturbance, the variance of the spot rate around its long-run equilibrium path greatly exceeds the variance of the forward rate as the role of speculative activity increases in the forward market. These model simulations provide an alternative to the null hypothesis of speculative efficiency in tests based on the relative variance of spot and forward exchange rates. Evidence is presented to demonstrate that the high observed variance of the forward rate relative to the variance of the spot rate is inconsistent with speculative efficiency.

Publication Type:	Thesis (Doctoral)
Subjects:	H Social Sciences > HG Finance
Departments:	Bayes Business School Bayes Business School > Bayes Business School Doctoral Theses Doctoral Theses

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