Abstract

The Simultaneous Determination of Spot and Forward Exchange Rates: An Asset Market Approach

The objective of this paper is to integrate the modern theory of forward exchange with the asset market approach to exchange rate determination, under conditions of imperfect substitutability between domestic and foreign securities. Such a synthesis produces a system that simultaneously determines the spot and forward exchange rates on a currency in a floating exchange rate environment, for a given level of exchange rate expectations. It then becomes possible to analyze the short-run (or “impact”) effect on exchange rates of various disturbances that are exogenous to the system, including government intervention in the exchange markets. The limiting cases of speculative and arbitrage risk neutrality also can be considered in this context. The major results of the paper are as follows. First, new information that alters the expected future spot rate produces proportionate changes in the spot and forward rates, regardless of the degree of speculative and arbitrage risk aversion. Second, an increase in the uncovered interest differential in favor of the home country, due, say, to a domestic open market operation, leaves the forward rate unchanged (with unchanged exchange rate expectations) but causes the spot rate on the foreign currency to fall. The result is an exactly offsetting increase in the forward premium on the foreign currency. Finally, government intervention in the spot or forward exchange markets causes spot and forward rates to move in the same direction as long as speculators are risk averse. However, if speculators are risk neutral, forward intervention has no effect on exchange rates; and if arbitrageurs are also risk neutral, sterilized intervention in the spot market has no exchange rate effects. Nevertheless, non-sterilized intervention in the spot market still alters the spot rate because of its impact on the domestic interest rate.