Fluctuating Exchange Rates

Fluctuating Exchange Rates



Fluctuating Exchange Rates

Introduction

There was a fixed exchange rate regime in the world during the Bretton Woods system. During that time period, the currencies of many countries were pegged against US dollar. Thus, the monetary growth was determined by growth in the US dollar or the currencies they were pegged to. The countries engaged with each other in export-import were facing no exchange rate fluctuation risk. But when this system of fixed exchange rate collapsed in 1973, it led to volatile currency exchange rate that had a direct impact on the financial transactions among the nations. Hence the need was felt for instrument which could manage this risk through hedging and also that could forecast to some extent the exchange rate in the future (Daigler, 2007, pp. 12).

Discussion

According to a study based on the forecasting accuracy of the forward rate, the forward rate and forward premium provide a good forecast of the future spot rate and the change in spot rate respectively.

Currency futures are characterized by risk premiums which can arise due to covariation of the futures price with consumption and wealth. If there are no ex-ante risk premiums, forward rate can be used as a good estimate of the future spot rate. When the prices are allowed to vary along with the conditional expected returns and the variances of the benchmark portfolio, there is found a strong evidence for risk premium, while if the parameters are held constant, no risk premium is observed. Thomas (1986) showed that the current spot price will be an unbiased predictor of the future spot price when the price of a commodity follows drift less random walk. If this is not so, then the futures prices will be at premia or at discount following the expectations of the investors. ...