A variable risk hypothesis in a forward exchange market

Whenever anticipated foreign exchange rate values determine, in part, the actions of forward exchange market speculators it is argued that changing amounts of risk (over time) will be reflected in the forward exchange rate. To suppose that risk has some constant impact on the price of foreign currencies (in terms of the speculator's currency) month after month rather that causing its value to change over time exposes the empirical model to unnecessary error from secular or cyclical exchange rate movements. Hence, since this dissertation seeks to demonstrate the significance of variable expectational risk in a speculative market while minimizing the effects of noise generated by random economic shocks, our model shall consist of a growth-oriented mechanism for producing estimates of the future exchange rate. This stands opposed to the models in which variables are level based.

This study employs declining, non-negative exponential weights on observed relative price levels to derive an alternate expectations formation mechanism. From this mechanism we produce two variable risk models. Each variable risk model is integrated into the growth-oriented expectations scheme; and then empirically tested against a non-variable risk model as well as the remaining variable risk scheme.

The statistical test results provide substantial evidence for accepting the hypothesis that variable (expectational) risk is an important factor in determining changes in certain forward exchange rate values. The tests offer unambiguous support of the growth-based expectations mechanism in every instance. The results also provide additional empirical evidence for studies which: (a.) employ the modern theory of foreign exchange and, (b.) have argued that there is a substantial amount of integration between the U.S. and Canadian economies.