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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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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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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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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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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Exhibit 7.1
Profits and Losses from Forward Market Speculation
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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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Exhibit 7.2
Exchange Rates Forecasts form May 23, 1995:
An Analysis
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Exhibit 7.3
Standard Normal Distribution
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Exhibit 7.4
Standard Deviation of Monthly Percentage Changes in
Exchange Rates and Forward Market Returns
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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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7.2 Uncovered Interest Rate Parity and the
Unbiasedness Hypothesis
• Introduction
• Uncovered interest rate parity
• Unbiasedness hypothesis
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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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7.2 Uncovered Interest Rate Parity and the
Unbiasedness Hypothesis
• Uncovered Interest Rate Parity
• 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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7.2 Uncovered Interest Rate Parity and the
Unbiasedness Hypothesis
• The Unbiasedness Hypothesis
• Unbiased predictor
• Unbiasedness Hypothesis and Forward Market
Returns
• The Siegel paradox (Advanced)
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7.3 Risk premiums in the Foreign
Exchange Market
Risk Premiums - Foreign Exchange Market:
Overview
• Introduction
• What Determines Risk Premiums?
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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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7.3 Risk premiums in the Foreign
Exchange Market
• What Determines Risk Premiums?
• Systematic risk
• Covariance
• Market portfolio
• Idiosyncratic risks
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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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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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7.4 Uncovered Interest Rate Parity and the
Unbiasedness Hypothesis in Practice
• Exchange Rate Forecasting
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7.4 Uncovered Interest Rate Parity and the
Unbiasedness Hypothesis in Practice
• Exchange Rate Determination
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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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7.5 Empirical Evidence on the
Unbiasedness Hypothesis
• The Quest for a Test
– Incorporating Rational Expectations into the
Test
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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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Exhibit 7.5
Means of Monthly Rates of Appreciation, Forward
Premiums, and the Differences Between the Two
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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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Exhibit 7.6
Regression Test of the Unbiasedness Hypothesis
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Exhibit 7.7
Interpreting the Unbiasedness Regression
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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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7.6 Alternative Interpretations of the
Test Results
• Do survey data reveal irrational
expectations?
– Problems with interpreting survey data
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Exhibit 7.8
Rolling Monthly 5-Year Regression: Monthly Spot Rate
% Change Versus Monthly Forward Premium
February 1976-September 2000
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7.6 Alternative Interpretations of the
Test Results
• Peso problems
– Statistical problems with unbiasedness
hypothesis regressions
– Peso problems
– Argentina in 2000
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7.6 Alternative Interpretations of the
Test Results
• Swedish Interest Rates of 500%
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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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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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Exhibit 7A.1
Data on Exchange Rates (USD/EUR) and
Forward Premiums (USD/EUR)
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Exhibit 7A.2
Exchange Rate Changes on Dollar/Euro
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Exhibit 7A.3
Chi-Square Distribution
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