Research: The relationship between the forward and realised spot exchange rate in SA Reply

Our Research posts are about the latest academic research being done in the School of Economics. This week:

THE RELATIONSHIP BETWEEN THE FORWARD- AND THE REALISED SPOT EXCHANGE RATE IN SA

By Chris van Heerden & André Heymans

The inability to effectively hedge against unfavourable exchange rate movements, using the current forward exchange rate as the only guideline, is a key inhibiting factor of international trade. Market participants use the current forward exchange rate quoted in the market to make decisions regarding future exchange rate changes. However, the current forward exchange rate is not solely determined by the interaction of demand and supply, but is also a mechanistic estimation, which is based only on the current spot exchange rate and the carry cost of the transaction (see Figure 1). Results of various studies, including this study, demonstrated that the current forward exchange rate differs substantially from the realised future spot exchange rate. This phenomenon is known as the exchange rate puzzle.

Figure 1: The current ZAR/USD spot and forward exchange rate
Source: Data from the McGregor BFA database.

This study contributes to the dynamics of modelling exchange rate theories by developing an exchange rate model that has the ability to explain the realised future spot exchange rate and the exchange rate puzzle. The exchange rate model is based only on current (time ) economic fundamentals and includes an alternative approach of incorporating the impact of the interaction of two international financial markets into the model. This study derived a unique exchange rate model, which proves that the exchange rate puzzle is a pseudo problem. The pseudo problem is based on the generally excepted fallacy that current non-stationary, level time series data cannot be used to model exchange rate theories, because of the incorrect assumption that all the available econometric methods yield statistically insignificant results due to spurious regressions. Empirical evidence conclusively shows that using non-stationary, level time series data of current economic fundamentals can statistically significantly explain the realised future spot exchange rate and, therefore, that the exchange rate puzzle can be solved.

Read the complete article in the latest issue of the Journal of Economic and Financial Sciences, 5(1): 175-192

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