Liquidity in the forward exchange market
There are a number of major anomalies that arise from forward foreign exchange rates. Though the level of the forward rate is an unbiased predictor of the future spot rate, the forward premium is 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. These conclusions emerge from, inter alia, Macklem (1991), Engel (1992) and Backus, Gregory and Telmer (1993). We construct a Lucas-Fuerst model of a two-country world. This framework provides rigorous foundations for liquidity constraints and premia. In our application, there are two insights. The first is that spot forex purchases require cash-in-advance just like goods in the standard Lucas model. However, forward contracts are not bound by this liquidity constraint. This drives a wedge between the spot and forward forex markets. The other insight is that the forward market is incomplete in that the agents that conduct the spot forex transactions in the goods market have a different information set to asset market traders. The model is then simulated using the techniques that are normally associated with the real business cycle literature. We compare its ability to overcome the 'anomalies' with the standard model. The results give rise to cautious optimism.
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