Showing papers on "Forward exchange rate published in 1982"

Currency Substitution and the Demand for Money: Some Evidence for Canada

Abstract: RECENTLY, THE POSSIBILITY THAT foreign and domestic currencies are substitutes has received considerable attention (see [1, 2, 3, 10, 19, 21]). Currency substitution has important implications for the working of flexible exchange rates. If the degree of currency substitution is high, small changes in the money supply would induce large changes in the exchange rate. Furthermore, currency substitution would transmit the effect of monetary disturbances from one country to another. Indeed, significant currency substitution would seriously undermine the ability of flexible exchange rates to provide monetary independence. This paper examines the empirical importance of currency substitution in the framework of the demand function for money. If currency substitution is important, the expected change in the exchange rate should be a significant determinant of the demand for home currency. In section 2, we undertake such a test for the Canadian demand for money during the recent flexible exchange rate period. There is considerable evidence that the forward exchange rate is a good measure of the expected exchange rate. Our own tests confirm these results for Canadian data since 1970.

The Effect of Errors in Variables on Tests for a Risk Premium in Forward Exchange Rates

Abstract: Conventional tests for a risk premium in the price of forward exchange use the subsequently realized spot rate as a proxy for prior expectations. Use of this proxy creates a serious errors-in-variables problem which makes it difficult to reject the null hypothesis of zero risk premium. Use of a better proxy for expectations indicates the presence of a risk premium in the forward exchange rate of all countries analyzed. IF THERE IS ZERO risk premium in the price of forward exchange, the forward rate will equal agents' expectations of the future spot rate. Since the expected future spot rate is not observed, investigators have had to construct an expectations proxy in order to test for a risk premium. The standard approach has been to use the subsequently realized spot rate as a proxy for prior expectations. This approach is justified by invoking the theory of rational expectations. If agents efficiently process all information, then the realized spot rate will differ from prior expectations by a zero mean, serially uncorrelated random variable. Given this expectations proxy, the presence of a risk premium is tested by regressing the future realized spot rate on the forward rate. Intercept and slope regression coefficients which are not significantly different from zero and unity respectively imply a zero risk premium. Such tests have generally been unable to reject the hypothesis of zero risk premium.1 It is the contention of this paper that the subsequently realized spot rate is a poor proxy for the prior expectations of rational agents. Use of this proxy creates a serious errors-in-variables problem in tests for a risk premium, and this makes it difficult to reject the null hypothesis. When a better proxy for expectations is employed, we find evidence of a risk premium in the price of forward exchange. As a result, the forward rate, uncorrected for the risk premium, does not provide unbiased market-implicit forecasts of the future spot rate.2

Theory of the multinational firm: fixed versus floating exchange rate *

Abstract: BATRA and Hadar's' paper examines the impact of various exchange rate regimes on the decision made by multinational (binational) firm. In their analysis of floating exchange rates they examine the significance of the forward exchange market. In this context their results and conclusions are counterintuitive since they claim that: "the impact of fluctuating exchange rates-depends crucially on the firm's expectation about the expected future spot rate (e) and the marginal cost functions (MC's). Thus, for example when the firm expects the exchange rate to exceed the cost of forward exchange i.e., e > q (where q is the forward exchange rate) and all marginal costs are rising, then home sales are increased while foreign sales and export are decreased, and at the same time, the firm reduces its production at home, and increases abroad."2 In this note we show that Batra and Hadar (abbreviated B & H) err in their conclusion, by arguing that the existence of forward markets allow the binational firm to separate the production, export and sales decisions from the forward market hedging decision. For a given current forward exchange rate, the management of the firm may treat foreign operation profits as if they were certain, since the firm can engage in forward sales of foreign currency resulting from foreign profits at the prevailing rate. The main implication is that the production and export decisions can be made based upon the forward rate and is independent of the uncertainty of the future spot rate, and consequently independent of the management degree of risk aversion. Given the domestic and foreign profits resulting from the production and export decisions the management has to determine the mix between covered and uncovered foreign profits. The relevant variables for this decision are: the current forward rate, the subjective future expected spot rate, and the degree of risk aversion of the firm's management. This sequence for the decision making process of the binational firm contrasts with Batra and Hadar's conclusions that the desired amount of forward cover is determined jointly with other decisions. A formal derivation of these results follows. To facilitate comparison we shall use the same model as Batra and Hadar. The firm operates in its home country and in the foreign country. In addition to production, the firm can ship its product from one country to another by means of intrafirm transfer. The gross profits in each country are