Page 178 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

International Trade and Finance

Notes assessment of the expected change in the spot rate. Moreover, slope coefficients in the regressions
of F – S t + 1 and S t + 1 – S on F – S that are reliably different from zero imply variation in both
t
t
t
t
components of F – S . However, negative covariation between P and E(S – S ) leads to negative
t t t t + 1 t
slope coefficients in the regressions of on F – S and preempts accurate measurement of the
t
t
variances of P and E(S t + 1 – S ). Given market efficiency or rationality, the only conclusion we
t
t
can draw from the negative slope coefficients in the S – S regressions and slope coefficients
t + 1 t
greater than 1.0 in the complementary regressions of F – S t + 1 on F – S is that the variance of the
t
t
t
P component of F – S is much larger than the variance of E(S – S ).
t t t t + 1 t
• Any forward rate can be interpreted as the sum of a premium and an expected future spot rate.
Thus, our regression approach to examining the components of forward rates has broad
applicability to financial and commodity market data. In Fama (1984), I apply the approach to
forward and spot interest rates on U.S. Treasury bills, with somewhat more success. For example,
unlike the forward exchange rate, which seems primarily to reflect variation in its premium
component, the difference between the forward one month interest rate for one month ahead
and the current one month spot interest rate, F – R , splits roughly equally between variation in
t
t
its premium component and variation in the expected change in the one month spot interest
rate. Moreover, in the interest rate data, F – R sometimes has a larger variance than the ex post
t
t
change in the one month spot interest rate, R t + 1 R . Perhaps as a consequence, the ex ante F – R t
t
t
explains from 15 to 70 percent of the variance of the ex post change in the spot interest rate,
R t + 1 – R . All of this is in striking contrast to the weak and somewhat perplexing picture that
t
emerges from the exchange rate data, where variation in the ex ante forward-spot differential,
F – S , is always small relative to the variation of the ex post change in the spot rate, S – S .
t t t + 1 t
14.4 Key-Words
1. Exchange rate : Rate at which one may be converted into another. The exchange rate is used
when simply converting one currency to another (such as for the purposes of
travel to another country), or for engaging in speculation or trading in the foreign
exchange market. There are a wide variety of factors which influence the
exchange rate, such as interest rates, inflation, and the state of politics and the
economy in each country, also called rate of exchange or foreign exchange rate
or currency exchange rate.
14.5 Review Questions
1. What is the meaning of Exchange Rate? Explain.
2. Discuss the components exchange rate.
Answers: Self-Assessment
1. (i)(a) (ii)(d) (iii)(e) (iv)(b) (v)(d)
14.6 Further Readings

1. Bilson, John F.O., 1981, The speculative efficiency hypothesis. Journal of Business
54, July, 435–451.
2. Breeden, Douglas T., 1979, An intertemporal asset pricing model with stochastic
consumption and investment opportunities, Journal of Financial Economics 7,
Sept., 265–296.
3. Domowitz, Ian and Craig S. Hakkio, 1983, Conditional variance and the risk
premium on the foreign exchange market, Manescript, Sept.
4. Fama, Eugene F. 1982, Inflation, output and money, Journal of Business 55, April,
201–231.

172 LOVELY PROFESSIONAL UNIVERSITY