Profitability and Stability in International Currency Markets

Abstract

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.