The relationship between the forward– and the realized spot exchange rate in South Africa / Petrus Marthinus Stephanus van Heerden
The inability to effectively hedge against unfavourable exchange rate movements, using thecurrent forward exchange rate as the only guideline, is a key inhibiting factor of internationaltrade. Market participants use the current forward exchange rate quoted in the market to makedecisions regarding future exchange rate changes. However, the current forward exchange rateis not solely determined by the interaction of demand and supply, but is also a mechanisticestimation, which is based on the current spot exchange rate and the carry cost of thetransaction. Results of various studies, including this study, demonstrated that the currentforward exchange rate differs substantially from the realized future spot exchange rate. Thisphenomenon is known as the exchange rate puzzle.This study contributes to the dynamics of modelling exchange rate theories by developing anexchange rate model that has the ability to explain the realized future spot exchange rate andthe exchange rate puzzle. The exchange rate model is based only on current (time t) economicfundamentals and includes an alternative approach of incorporating the impact of the interactionof two international financial markets into the model. This study derived a unique exchange ratemodel, which proves that the exchange rate puzzle is a pseudo problem. The pseudo problemis based on the generally excepted fallacy that current non–stationary, level time series datacannot be used to model exchange rate theories, because of the incorrect assumption that allthe available econometric methods yield statistically insignificant results due to spuriousregressions. Empirical evidence conclusively shows that using non–stationary, level time seriesdata of current economic fundamentals can statistically significantly explain the realized futurespot exchange rate and, therefore, that the exchange rate puzzle can be solved.This model will give market participants in the foreign exchange market a better indication ofexpected future exchange rates, which will considerably reduce the dependence on themechanistically derived forward points. The newly derived exchange rate model will also have an influence on the demand and supply of forward exchange, resulting in forward points that area more accurate prediction of the realized future exchange rate.
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