Handout 2: The Foreign Exchange Market 1
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1 University of Bern Prof. H. Dellas International Finance Winter semester 01/02 Handout 2: The Foreign Exchange Market 1 1 Financial Instruments in the FOREX markets Forward contracts Large, non standardized amounts, 1,3,6,12 months Futures Tradeable standardized contracts, smaller amounts, specific maturity dates Margin requirement Swaps Interest swaps; FX swaps; Currency swaps Options Put; Call Striking (exercise) price; Option prices (premia) Out/ in/ at the money 1.1 A comparison of derivatives Flexibility (obligation vs righ Default (credi risk. Riskiness: 1 The FOREX is the most active market among financial markets: Spot (rate for current transactions) vs forward (rate agreed upon today for future transactions) 1
2 Forwards > swaps > futures 1.2 Financial engineering All derivatives can be reduced into some other derivative. Swaps and futures are simply portfolios of forward contracts! Options can be replicated by combining forwards (or swaps or futures) and risk free securities Put-call parity (calls and puts can be combined to become forwards) Payoff profiles = + = + Forwards/Futures/Swaps Options 2
3 2 On the efficiency of FOREX markets Covered interest rate parity holds well CIRP: i( i * ( = f ( s( There is no possibility of making risk free profits Tests of market efficiency center on uncovered interest rate parity Alternative 1: er = i * ( i( + [ s( t + 1) s( ] = s( t + 1) f ( Calculate excess returns (profits) -er- on foreign exchange: Predicted excess returns: per = Es( t + 1) f ( Regress per on currently known variables (such as past er) Are FX profits predictable? If yes, what does this mean for efficiency? Alternative 2 (see Froot and Thaler (1990): s ( t + 1) s( = a + b[ i( i *( ] + u( or s ( t + 1) s( = a + b[ f ( e] + u( Test hypothesis: a = 0 ; b = 1 Many estimates of b exist in the literature. The average value across these studies: b = (!) 3
4 Enjoy on average- higher interest rates and get capital gains too! Why should one bother to hold currencies like the CHF or the Yen which offer bear such low interest rates? Answer: Foolishness, incompetence or risk (see proceeding section). 3 Possible explanations for the failure of the hypothesis i *( i( = s( f ( = s( E s( t + 1) + E s( t + 1) f ( Expected depreciation + risk premium Existence of a (time-varying) risk premium Systematic expectational errors An example: t t Risk premium Systematic expectational errors f( = E t s(t+1) c s(t+1) = E t s(t+1) + a + u(t+1) 3.1 Risk premia People may on average form an accurate expectation of the future exchange rate They, however, may not use the expected value as the price for future transactions. They may adjust for risk Analogy to insurance premia under risk aversion. A risk averse individual will accept less then the expected value of a gamble. It is not sufficient to postulate that the existence of excess returns is due to risk aversion and risk premia 4
5 One must be able to relate the predictable components of e(t+1) f( to the economic determinants of risk premia e(t+1) f( risk aversion, structures of returns (conditional variance, variability of consumption) Many different types of models (partial and general equilibrium) have been used to derive the determinants of the risk premium Problem: The Fama result b < ½ implies Var(per) > Var[E t s(t+1) - s(] No economic model of the risk premium has been able to generate the required variability in predicted excess returns. That is, the determinants of the RP do not vary sufficiently 3.2 Systematic expectational errors Irrational systematic expectational errors Expectations are not directly observable Use survey data in place of expectations. They indicate systematic misses. Should survey data be taken seriously? Rational systematic expectational errors Learning Peso problem Technical analysis Have the various trading rules proved profitable? Review of trading rules (filters, MA ) 5
![s(t+1) - s(] No economic model of the risk premium has been able to generate the required variability in predicted excess returns. That is, the determinants of the RP do not vary sufficiently 3.](/docs-images/51/14509550/images/page_5.jpg "2 Systematic expectational errors Irrational systematic expectational errors Expectations are not directly observable Use survey data in place of expectations. They indicate systematic misses.")
6 The difference between ex ante and ex post profitability Overall conclusion: Judging the efficiency of the FOREX market is a subjective matter 6
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