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Liquidity in the Forward Exchange Market

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Author Info
MICHAEL J MOORE
MAURICE J. ROCHE

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Abstract

There are a number of major 'anomalies' associated with forward foreign exchange rates. Though the level of the forward rate is an unbiased predictor of the future spot rate, the forward premium is a poor predictor of future spot rate changes; speculative profits are so volatile that implausibly large degrees of risk aversion are required to explain them and finally, the forward premium is 'excessively' autoregressive. We construct a two-country limited participation model along the lines of the closed economy Lucas (1990) model. Spot foreign exchanged purchases require cash-in-advance. However forward contracts are not bound by this liquidity constraint. This drives a wedge between the spot and forward foreign exchange markets. We compare the limited participation model's ability to overcome the 'anomalies' with the standard model. The results give rise to cautious optimism.

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Paper provided by Financial Services Research Forum in its series Financial Market Papers with number 6.

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Handle: RePEc:fsr:fsrewp:6

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Web page: http://www.business.ulster.ac.uk/retailfinancial/
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  1. Peter G. Szilagyi & Jonathan A. Batten, 2006. "Arbitrage, Covered Interest Parity and Long-Term Dependence between the US Dollar and the Yen," The Institute for International Integration Studies Discussion Paper Series iiisdp128, IIIS. [Downloadable!]
  2. Maurice J. Roche & Michael J. Moore, 1999. "Less of a puzzle: a new look at the forward forex market," Economics, Finance and Accounting Department Working Paper Series n910799, Department of Economics, Finance and Accounting, National University of Ireland - Maynooth. [Downloadable!]
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This page was last updated on 2009-12-28.

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