Abstract

Financial Economists have intensively examined whether currency forward prices are unbiased and efficient estimators of future spot rates. The mechanism of Interest Rate Parity (IRP) in combination with the Efficient Markets Hypothesis (EMH) would suggest that forward rates should be unbiased estimates of future spot rates. This is referred to as the Unbiased Forward Rate Hypothesis (UFRH). However, extensive empirical evidence has refuted this hypothesis. Much of the empirical studies have relied on US Dollar based investors, considered a single forward period and relied on often complex econometrics to test the predictive ability of forward prices.

In this work, we examine the problem from the point of a Euro investor/borrower for the period from 1991 to 2005. This study also considers multiple maturities of forward contracts from 1 month to 10 years. We also provide a simpler method of assessing the relationship between forward prices and future spot prices. We find that a significant bias occurs between forward prices and future spot prices. Of particular interest is that there appears to be a profitable trading strategy from buying uncovered forward contracts for low interest rate currencies. To better understand the biased relationship, a funding scenario is examined where a Euro investor borrows in the foreign currency and invests in the Euro without a forward hedge. There is a significant average profit from borrowing in Swiss Franc, Japanese Yen and US Dollar (when the US$ rate is lower than the € rate). It is shown that such a strategy leads to a significant loss for the Euro versus the British Pound. This analysis also considers a “switching” rule for such funding strategies and finds optimal spreads in the interest rate differential yield significant increases in expected profits and reduction in the risk (standard deviation of funding P/L).

For this period of analysis, it appears that forward discount currencies do not appreciate as much in the spot market as is indicated by the forward price. Likewise, forward premium currencies do not depreciate as much in the future as is indicated by the forward price. The mechanism for this result is unknown but is consistent with a mean reverting currency rate.

These results are then stress-tested by simulation using the Unconditional Disturbances approach of Tompkins & D’Ecclescia (2005) and the general results from the Historical record are found to be robust to alternative paths of future spot rates.

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Thursday Oct 20 2005 6:00 p.m., HfB Room 3