Chapter 7: Speculation and Risk in the Foreign Exchange Market Power Points created by: Joseph F. Greco Ph. D. California State University, Fullerton Mihaylo College of Business and Economics Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Chapter 7: Speculation and Risk in the Foreign Exchange Market 7.1 Speculating in the Foreign Exchange Market 7.2 Uncovered Interest Rate Parity and the Unbiasedness Hypothesis 7.3 Risk premiums in the Foreign Exchange Market 7.4 Uncovered Interest Rate Parity and the Unbiasedness Hypothesis in Practice Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

7.1 Speculating in the Foreign Exchange Market Speculating - Foreign Exchange Market: Overview Uncovered Foreign Money Market Investments Speculating With Forward Contracts Currency Speculation and Profits and Losses Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

7.1 Speculating in the Foreign Exchange Market Uncovered Foreign Money Market Investments What happens when an investor or trading firm does not hedge the exchange rate risk? Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

7.1 Speculating in the Foreign Exchange Market Speculating With Forward Contracts The break-even spot rate Comparing forwards market and foreign money market investments Forward market investment Forward market return Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Exhibit 7.1 Profits and Losses from Forward Market Speculation Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

7.1 Speculating in the Foreign Exchange Market Currency Speculation and Profits and Losses Some observable expectations Forecast errors Quantifying expected losses and profits Information set Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Exhibit 7.2 Exchange Rates Forecasts form May 23, 1995: An Analysis Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Exhibit 7.3 Standard Normal Distribution Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Exhibit 7.4 Standard Deviation of Monthly Percentage Changes in Exchange Rates and Forward Market Returns Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

7.2 Uncovered Interest Rate Parity and the Unbiasedness Hypothesis Uncovered Interest Rate Parity and Unbiasedness Hypothesis: Overview Introduction Exchange Rate Forecasts and Market Efficiency Uncovered Interest Rate Parity The Unbiasedness Hypothesis Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

7.2 Uncovered Interest Rate Parity and the Unbiasedness Hypothesis Introduction Uncovered interest rate parity Unbiasedness hypothesis Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

7.2 Uncovered Interest Rate Parity and the Unbiasedness Hypothesis Exchange Rate Forecasts and Market Efficiency Forecast errors Market efficiency and forecasting Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

7.2 Uncovered Interest Rate Parity and the Unbiasedness Hypothesis Is the hypothesis that the expected return on the uncovered foreign investment equals the known return from investing $1 in the dollar money market Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

7.2 Uncovered Interest Rate Parity and the Unbiasedness Hypothesis Unbiased predictor Unbiasedness Hypothesis and Forward Market Returns The Siegel paradox (Advanced) Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

7.3 Risk premiums in the Foreign Exchange Market Risk Premiums - Foreign Exchange Market: Overview Introduction What Determines Risk Premiums? Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

7.3 Risk premiums in the Foreign Exchange Market Introduction Risk premium The expected return on the asset in excess of the return on a risk-free asset Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

7.3 Risk premiums in the Foreign Exchange Market What Determines Risk Premiums? Systematic risk Covariance Market portfolio Idiosyncratic risks Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 7.4 Uncovered Interest Rate Parity and the Unbiasedness Hypothesis in Practice Uncovered Interest Rate Parity and the Unbiasedness Hypothesis in Practice: Overview International Portfolio Management Exchange Rate Forecasting Exchange Rate Determination The Cost of Hedging Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 7.4 Uncovered Interest Rate Parity and the Unbiasedness Hypothesis in Practice International Portfolio Management Portfolios that hold both local and foreign securities will be exposed to exchange rate risk Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 7.4 Uncovered Interest Rate Parity and the Unbiasedness Hypothesis in Practice Exchange Rate Forecasting Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 7.4 Uncovered Interest Rate Parity and the Unbiasedness Hypothesis in Practice Exchange Rate Determination Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 7.4 Uncovered Interest Rate Parity and the Unbiasedness Hypothesis in Practice The Cost of Hedging Multinational corporations often hedge using forward contracts Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

7.5 Empirical Evidence on the Unbiasedness Hypothesis The Quest for a Test Incorporating Rational Expectations into the Test Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

7.5 Empirical Evidence on the Unbiasedness Hypothesis A Test Using the Sample Means Data on Rates of Appreciation and Forward Premiums The Test Implications: High-Interest-Rate Currencies Depreciate Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Exhibit 7.5 Means of Monthly Rates of Appreciation, Forward Premiums, and the Differences Between the Two Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

7.5 Empirical Evidence on the Unbiasedness Hypothesis Regression Tests of the Unbiasedness of Forward Rates The Test The Test Results A Popular Interpretation Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Exhibit 7.6 Regression Test of the Unbiasedness Hypothesis Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Exhibit 7.7 Interpreting the Unbiasedness Regression Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

7.6 Alternative Interpretations of the Test Results Risk Premiums Decomposing the forward premium The variability of the forward premium and its components Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

7.6 Alternative Interpretations of the Test Results Do survey data reveal irrational expectations? Problems with interpreting survey data Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Exhibit 7.8 Rolling Monthly 5-Year Regression: Monthly Spot Rate % Change Versus Monthly Forward Premium February 1976-September 2000 Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

7.6 Alternative Interpretations of the Test Results Peso problems Statistical problems with unbiasedness hypothesis regressions Argentina in 2000 Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

7.6 Alternative Interpretations of the Test Results Swedish Interest Rates of 500% Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Appendix 7.1- The Portfolio Diversification Argument and the CAPM Review how the mean and variance of a portfolio are determined when there is more than one asset in the portfolio Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Appendix 7.1- A Regression Refresher Exhibit 7A.1 Data on Exchange Rates (USD/EUR) and Forward Premiums (USD/EUR) Exhibit 7A.2 Exchange Rate Changes on Dollar/Euro Exhibit 7A.3 Chi-Square Distribution Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Exhibit 7A.1 Data on Exchange Rates (USD/EUR) and Forward Premiums (USD/EUR) Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Exhibit 7A.2 Exchange Rate Changes on Dollar/Euro Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Exhibit 7A.3 Chi-Square Distribution Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall