The Forward Parity Condition

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The Forward Parity Puzzle

John F. O. Bilson
Melbourne Business School The University of Melbourne

August, 2003

Keywords: Market Efficiency, Exchange Rates, International Finance JEL Classification: F31, G15, G14



The forward parity condition states that the forward exchange rate is an unbiased and efficient forecast of the future spot rate. The condition is an implication of market efficiency in the absence of a time varying risk premium. There have been numerous tests of the forward parity condition in the academic and applied literature on foreign exchange markets and these tests have led to a unanimous rejection of the forward parity condition. Not only has the forward rate failed to predict the future spot rate, but it has generally pointed in the wrong direction. If the forward rate is above the current spot rate, the future spot rate is more likely to fall than rise. Since the forward rate is a reflection of short term interest rate differentials, the failure of the forward parity condition implies that high yielding currencies have tended to appreciate against low yielding currencies. This is equivalent to high dividend stocks appreciating in value against low dividend stocks. The purpose of this paper is to review and extend the early literature on the forward parity condition. The results suggest that the simple interest rate differential model should be replaced with a more sophisticated model based upon both real and nominal interest rate differentials. The extended model has continued to exhibit surprising levels of profitability through the recent period of greater monetary stability.



Introduction The forward exchange rate plays two distinct roles in the foreign exchange market. Through the interest rate parity condition, the forward rate provides a link between the spot exchange rate and short term interest rate differentials. When offshore deposit rates are employed as representative short term interest rates, the interest rate parity condition holds very tightly. Market participants often state that forward exchange rates are mechanically priced off the interest rate parity relationship. The second role for the forward rate is as a forecast of the future spot rate. The forward parity condition states that the forward exchange rate is an efficient and unbiased forecast of the future spot rate. The immediate implication of this condition is that short term interest rate differentials are determined by expectations of the appreciation or depreciation of the exchange rate. The alternative view is that interest rates are predominantly determined by domestic economic conditions and monetary policy. If the central bank tightens monetary policy, this will cause short term interest rates to increase relative to US dollar rates. The higher interest rates will make the local currency more attractive to international investors. In their attempt to take advantage of this opportunity, the investors will bid up the local currency. In equilibrium the appreciation will be sufficient to induce expectations of a subsequent depreciation which will offset the benefit of the higher short term interest rate. This description of the market, which was originally developed by Rudiger Dornbusch (1976), neatly combined the domestic determination of interest rates with the forward parity condition. The forward parity condition can be derived from the hypothesis that the excess rate of return from foreign exchange speculation is zero. Consider a strategy of borrowing one dollar and investing the proceeds in a foreign currency. The end of period payoff on the strategy is then: St +1 (1 + it* ) − (1 + it ) St where S represents the exchange rate, expressed as the US dollar price of a unit of the foreign currency, i* is the foreign...
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