Profitability and Stability in International Currency Markets

A number of recent empirical studies have rejected the hypothesis that forward exchange rates are unbiased forecasts of future spot exchange rates. This result implies that there have been opportunities for speculative profit during the post Bretton Woods period. Observers of the floating rate system have also noted that exchange rates have been more volatile than they were anticipated to be in the 1960's. In this paper, the link between the volatility of exchange rates and the existence of opportunities for speculative profit is explored. The question answered in the paper is the following: if there were no opportunities for speculative profit, would exchange rates have been more stable? The answer is yes. This answer implies that speculation (intervention) based upon the forecasting equation described in the paper would be both profitable and stabilizing.

The Profitability of Currency Speculation

This paper presents the results of a post-sample simulation of a speculative strategy using a portfolio of foreign currency forward contracts.The main new features of the speculative strategy are (a)the use of Kalman filters to update the forecasting equation, (b) the allowance for transactions,costs and margin requirements and (c) the endogenous determination of the leveraging of the portfolio. While the forecasting model tended to overestimate profit and underestimate risk, the strategy was still profitable over a three year period and it was possible to reject the hypothesis that the sum of profits was zero. Furthermore, the currency portfolio was found to have an extremely low market risk. Combinations of the speculative currency portfolio with traditional portfolios of U.S. equities resulted in considerable improvements in risk-adjusted returns on capital.

Dynamic Adjustment and the Demand for International Reserves

Although there have been a large number of empirical studies of the demand for international reserves, there have not been many successful demonstrations that deviations of the actual stock of reserves from the target level defined by the demand function trigger a process of adjustment. This paper presents new evidence which suggests that central banks do have a target level of international reserve holdings, and that the adjustment of actual reserves towards the target level is quite rapid. In addition, an economic theory of the speed of adjustment is presented and tested. The evidence suggests that central banks adjust more rapidly to reserve deficiencies than to surpluses, that the speed of adjustment is positively related to the divergence between the actual level of reserves and the target level, and that countries which hold abnormally large quantities of reserves do so, in part, in order to adjust more slowly. Finally, the paper examines the applicability of the model to the current regime of managed flexible exchange rates. The evidence suggests that the move towards greater exchange rate flexibility has not significantly altered the reserve holding behavior of the world's central banks.

The "Speculative Efficiency" Hypothesis

The hypothesis that forward prices are the best unbiased forecast of future spot prices is often presented in the economic and financial analysis of futures markets. This paper considers the hypothesis independently of its implications for rational expectations or market efficiency and in order to stress this fact, the term "speculative efficiency" is used to characterize the state envisaged under the hypothesis. If a market is subject to efficient speculation, the supply of speculative funds is infinitely elastic at the forward price that is equal to the expected future spot price. The expected future spot price is a market price determined as the solution to the underlying rational expectations macroeconomic model. Although the paper is primarily concerned with testing this hypothesis in the foreign exchange market, the methodology introduced in the paper is of general application to all futures markets.