1. 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
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2. 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
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3. 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
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4. 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?
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5. 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
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6. Exhibit 7.1 Profits and Losses from Forward Market Speculation
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7. 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
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8. Exhibit 7.2 Exchange Rates Forecasts form May 23, 1995:
An Analysis
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9. Exhibit 7.3 Standard Normal Distribution
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10. 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
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11. 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
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12. 7.2 Uncovered Interest Rate Parity and the Unbiasedness Hypothesis
Introduction
Uncovered interest rate parity
Unbiasedness hypothesis
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13. 7.2 Uncovered Interest Rate Parity and the Unbiasedness Hypothesis
Exchange Rate Forecasts and Market Efficiency
Forecast errors
Market efficiency and forecasting
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14. 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
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15. 7.2 Uncovered Interest Rate Parity and the Unbiasedness Hypothesis
Unbiased predictor
Unbiasedness Hypothesis and Forward Market Returns
The Siegel paradox (Advanced)
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16. 7.3 Risk premiums in the Foreign Exchange Market
Risk Premiums - Foreign Exchange Market: Overview
Introduction
What Determines Risk Premiums?
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17. 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
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18. 7.3 Risk premiums in the Foreign Exchange Market
What Determines Risk Premiums?
Systematic risk
Covariance
Market portfolio
Idiosyncratic risks
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19. 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
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20. 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
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21. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall
7.4 Uncovered Interest Rate Parity and the Unbiasedness Hypothesis in Practice
Exchange Rate Forecasting
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22. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall
7.4 Uncovered Interest Rate Parity and the Unbiasedness Hypothesis in Practice
Exchange Rate Determination
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23. 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
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24. 7.5 Empirical Evidence on the Unbiasedness Hypothesis
The Quest for a Test
Incorporating Rational Expectations into the Test
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25. 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
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26. 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
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27. 7.5 Empirical Evidence on the Unbiasedness Hypothesis
Regression Tests of the Unbiasedness of Forward Rates
The Test
The Test Results
A Popular Interpretation
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28. Exhibit 7.6 Regression Test of the Unbiasedness Hypothesis
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29. Exhibit 7.7 Interpreting the Unbiasedness Regression
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30. 7.6 Alternative Interpretations of the Test Results
Risk Premiums
Decomposing the forward premium
The variability of the forward premium and its components
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31. 7.6 Alternative Interpretations of the Test Results
Do survey data reveal irrational expectations?
Problems with interpreting survey data
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32. 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
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33. 7.6 Alternative Interpretations of the Test Results
Peso problems
Statistical problems with unbiasedness hypothesis regressions
Argentina in 2000
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34. 7.6 Alternative Interpretations of the Test Results
Swedish Interest Rates of 500%
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35. 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
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36. 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
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37. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall
Exhibit 7A.1 Data on Exchange Rates (USD/EUR) and Forward Premiums (USD/EUR)
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38. Exhibit 7A.2 Exchange Rate Changes on Dollar/Euro
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39. Exhibit 7A.3 Chi-Square Distribution
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