THE ROLE OF SPECULATION IN THE FORWARD EXCHANGE MARKET: SOME CONSISTENT ESTIMATES ASSUMING RATIONAL EXPECTATIONS
| Date | 01 August 1987 |
| Published date | 01 August 1987 |
| DOI | http://doi.org/10.1111/j.1468-0084.1987.mp49003005.x |
| Author | Mark P. Taylor |
OXFORD BULLETIN OF ECONOMICS AND STATISTICS, 49,3 (1987)
0305-9049 $3.00
THE ROT F. OF SPECULATION IN THE
FORWARD EXCHANGE MARKET: SOME
CONSISIENT ESTIMAI ES ASSUMING
RATIONAL EXPECTATIONS
Mark P. Taylor*
I. INTRODUCTION
The 'modem theory' of forward exchange sees the forward foreign
exchange rate as being jointly determined by the actions of speculators
and covered interest rate arbitragers (see for example, Tsiang, 1959;
Grubel, 1966; Stoll, 1968; Kesselman, 1971; Haas, 1974; McCallum,
1977). The econometrics of this approach essentially involves estimat-
ing an equilibrium condition which expresses the forward rate as a
weighted average of the interest-parity forward rate and the expected
future spot rate. By examining the relative size and statistical signifi-
cance of the estimated weights, some light may also be shed on the
relative importance of speculative influences and covered arbitrage in
forward rate determination.
McCallum (1977) was the first to explicitly apply rational expecta-
tions in this framework, in his analysis of the Canadian float from 1953
to 1960. However, McCallum uses an inappropriate technique to cope
with the serial correlation in his model which is induced by incorporat-
ing expectations more than one step ahead. As a result, his estimates
are biased and inconsistent.
The purpose of the present paper is to provide estimates of the
rational expectations modern theory equilibrium condition for the
recent period of floating exchange rates. We use high-quality weekly
data for the (US) dollar-(French) franc and (US) dollar-(UK) sterling
exchange rates, and utilize a generalized method of moments estimator
developed by Hansen (1982) to yield consistent and efficient estimates.
II. THE MODERN THEORY OF FORWARD EXCHANGE
The starting point for the modern theory is to express excess demand
functions for forward foreign exchange. Let F be the current forward
* I am grateful to an anonymous referee and the editorial board, in particular Stephen
Nickell, for comments on a previous draft of this paper. The usual disclaimer applies. Any views
expressed are those of the author and are not necessarily those of the Bank of England.
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