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Liquidity in the forward exchange market

  • Moore, Michael J.
  • Roche, Maurice J.

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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Article provided by Elsevier in its journal Journal of Empirical Finance.

Volume (Year): 8 (2001)
Issue (Month): 2 (May)
Pages: 157-170

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Handle: RePEc:eee:empfin:v:8:y:2001:i:2:p:157-170
Contact details of provider: Web page: http://www.elsevier.com/locate/jempfin

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  1. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 1996. "Sticky price and limited participation models of money: a comparison," Working Paper Series, Macroeconomic Issues WP-96-28, Federal Reserve Bank of Chicago.
  2. Alan C. Stockman & Linda L. Tesar, 1991. "Tastes and technology in a two-country model of the business cycle: explaining international co-movements," Working Paper 9019, Federal Reserve Bank of Cleveland.
  3. Baillie, Richard T & Bollerslev, Tim, 1994. "The long memory of the forward premium," Journal of International Money and Finance, Elsevier, vol. 13(5), pages 565-571, October.
  4. Charles Engel, 1990. "On the foreign exchange risk premium in a general equilibrium model," Research Working Paper 90-06, Federal Reserve Bank of Kansas City.
  5. Grilli, Vittorio & Roubini, Nouriel, 1992. "Liquidity and exchange rates," Journal of International Economics, Elsevier, vol. 32(3-4), pages 339-352, May.
  6. Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, vol. 3(2), pages 123-192, June.
  7. Moore, Michael J, 1994. "Testing for Unbiasedness in Forward Markets," The Manchester School of Economic & Social Studies, University of Manchester, vol. 62(0), pages 67-78, Suppl..
  8. Sibert, Anne, 1996. "Unconventional preferences: do they explain foreign exchange risk premia?," Journal of International Money and Finance, Elsevier, vol. 15(1), pages 149-165, February.
  9. Abul M.M. Masih & Rumi Masih, 1998. "A Fractional Cointegration Approach to Testing Mean Reversion Between Spot and Forward Exchange Rates: A Case of High Frequency Data with Low Frequency Dynamics," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 25(7&8), pages 987-1003.
  10. David K. Backus & Allan W. Gregory & Chris I. Telmer, 1990. "Accounting for Forward Rates in Markets for Foreign Currency," Working Papers 792, Queen's University, Department of Economics.
  11. Bekaert, Geert, 1994. "Exchange rate volatility and deviations from unbiasedness in a cash-in-advance model," Journal of International Economics, Elsevier, vol. 36(1-2), pages 29-52, February.
  12. Tiff Macklem, R., 1991. "Forward exchange rates and risk premiums in artificial economies," Journal of International Money and Finance, Elsevier, vol. 10(3), pages 365-391, September.
  13. Fuerst, Timothy S., 1992. "Liquidity, loanable funds, and real activity," Journal of Monetary Economics, Elsevier, vol. 29(1), pages 3-24, February.
  14. Hassler, Uwe & Wolters, Jurgen, 1995. "Long Memory in Inflation Rates: International Evidence," Journal of Business & Economic Statistics, American Statistical Association, vol. 13(1), pages 37-45, January.
  15. Lucas, Robert Jr., 1990. "Liquidity and interest rates," Journal of Economic Theory, Elsevier, vol. 50(2), pages 237-264, April.
  16. Baillie, Richard T & Chung, Ching-Fan & Tieslau, Margie A, 1996. "Analysing Inflation by the Fractionally Integrated ARFIMA-GARCH Model," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 11(1), pages 23-40, Jan.-Feb..
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