8.3 Other foreign exchange market rules

But notice that if we were to accept the three rules above, expected ination rates

would be equal to two things: the expected change in spot exchange rates and the

difference in interest rates. It follows that in equilibrium, differences in interest rates

must equal the expected changes in the spot rates of exchange. This equality is

sometimes known as the international Fisher effect or the Fisher open hypothesis.

8.3.3Equilibrium in the forex markets

Next, we must distinguish between forward rates of exchange and the future spot

rate of exchange. The one-month forward rate is a rate agreed now for a delivery of

currency in one month’s time and thus is known. The future spot rate one month

ahead is what the spot rate will be in one month’s time and is unknown. However,

by assuming perfect markets (implying perfect information about present and future

values of variables), we would establish a link between the two.

Covered interest parity establishes, remember, a link between interest rate dif-

ferentials and forward rates of exchange. But the combination of purchasing power

parity and the Fisher effect establishes a link between interest rate differentials and

expected future spot rates of exchange. It follows that if people behave rationally and

are perfectly informed, and all the other assumptions of perfect markets hold, forward

rates of exchange will accurately predict movements in spot rates of exchange.

In other words, in a system of perfect markets, spot and forward exchange rates

would adjust immediately to any new information received and the existing forward

rates would be a good predictor of future spot rates of exchange. This is because

someone needing foreign currency in three months’ time could either buy it now

three months forward at the existing forward rate or could wait and buy it in

three months’ time at the spot rate of exchange then ruling. In a perfectly informed

market, the cost of these two actions must be equal. If they were not equal, a prot-

able arbitrage opportunity would exist and the actions of arbitrageurs would bring

the two rates into equality.

In practice, the forward rate is not a perfect predictor of the future spot rate.

Firstly, some uncertainty attaches to future spot rates of exchange because they might

always be affected by unpredictable news reaching the market. But to be genuinely

unpredictable, news would need to occur randomly since if there is a pattern to the

occurrence of news, well-informed markets would be able to discern it and would

be able to predict the news. Random events have an equal chance of being of the

type that would cause the exchange rate to rise and of the type that would cause

it to fall. This implies that forecasting errors resulting from news should cancel out

over time. Nonetheless, market-makers must allow for the possibility of change, and

we would thus expect the spread between bid and offer rates to be greater in the

forward market than in the spot market. That is, transaction costs should be higher

in the forward market.

Secondly, and more importantly than the occurrence of some genuinely unpre-

dictable events, information is neither perfect nor free. There are costs and benets

associated with acquiring additional information, and at some point the costs of

doing so outweigh the gains from being able to make an even better forecast of the

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Chapter 8 • Foreign exchange markets

future spot rate of exchange. Further, the costs of obtaining information are greater

for some market participants than others as are the benets available from making

an accurate forecast of future rates. It follows that the costs in money and time of

collecting and interpreting information that is relevant to future exchange rates ensures

both that market participants will not have full access to all relevant information

and that some market participants will have an advantage over others, violating two

conditions of perfect markets.

We might accept this but still wish to argue that forward rates better predict future

spot rates than do other methods of forecasting exchange rates. In proposing this,

we might particularly stress the role of speculators in the market. Speculators might

bet on the relationship between, say, the three-month forward rate and the actual

spot exchange rate in three months’ time. If the forward rate does not on averageequal

the future spot rate, speculators are missing prot opportunities. For example, if the

forward price of the euro were typically less than the spot rate when the forward

contract matured, one could regularly buy the euro forward and then, on the delivery

date, sell the euro spot and make a net prot.

It follows that all one needs to assume is that speculators are abundant and well-

informed and dominate the forward market. In this case, speculation is stabilising–

it pushes the exchange rate back towards its equilibrium rate – and performs the same

role as arbitrage does in a case where no risk is involved. This might be sufcient to

make forward rates of exchange a fairly reliable guide, on average, to future spot rates

of exchange.