Exchange Rate In Pakistan: A Dollar Rupee Case


Since the advent of asset price valuation the forward spot relationship continues to be of great importance from the portfolio managers, investors and policy makers point of view. Apart from being very important from the economic perspective, the most intriguing part of this relationship is that inspite of the large trading volumes and low trading costs seemingly large and persistent deviations from efficiency and rationality exists. Traditionally forward exchange rates are being used as the traditional proxies for expected future spot rates. This notion is practiced with the support of results of traditional studies finding the forward rate to be the an unbiased predictor of future spot rates. Such findings were reported by many, including Kohlhagen (1975), Cornell (1977), Longworth (1981), Frenkel (1982), and Edwards (1982 and 1983). This unbiasedness is later rejected by many studies, as they found evidence of risk premiums in major forward exchange markets making it a biased predictor. These results were evident from the work of Hansen and Hodrick (1980 and 1983), Agmon and Amihud (1981), Fama (1984), Somanath (1984), Domowitz and Hakkio (1985), Korajczyk (1985), and Chiang (1986 and 1988).In essence, the efficient market hypothesis states that market prices reflect available information. Since investors' expectations of the future spot rate are part of the available information set, these expectations should be reflected in market prices. Therefore, it has been argued that a consensus market forecast of the future spot rate is available "simply" by observing market prices.


By the efficient-markets hypothesis, we mean the proposition that the expected rate of return to speculation in the forward foreign exchange market conditioned on available information is zero. Several authors have noted theoretical problems with this proposition since it ignores some intertemporal allocation and risk considerations. These theoretical arguments indicate that one should not equate empirical rejection of this notion of efficiency with evidence of market failure. However, this does not remove all interest in tests of the hypothesis. The extent to which these exchange markets can be characterized approximately as efficient markets remains an interesting question that can best be answered through formal econometric analysis In the recent decades there have been an extensive research and empirical studies in the area of unbiased forward rate hypothesis. Some researchers found results supporting the UFH and some found results opposing UFH. The UFH being the core of studies discusses that the forward rate is the total reflection of the available information about the exchange rate expectations (Chiang 1988). As researched one view of market efficiency states that the current prices reflect all available information. When this is applied to the foreign exchange market, it implies that 'economic agents' expectations about future values of exchange rate determinants are fully reflected in the forward rates (Chiang 1988)." A basic understanding of difference between the spot market and forward market is necessary to understand the UFH perfectly. Transactions taking place in spot market involves two parties arranging to conduct the exchange of currencies in a relatively short term horizon. Whereas a forward transaction is a way to arrange in advance to buy foreign exchange for the purpose of making a future international payment. Purchasing or selling the foreign exchange forward allows those involved with the transaction to agree upon the exchange rate today. A forward rate can be interpreted as the sum of a premium and the expected future spot rate (Fama 1984). More precisely, "The forward exchange rate ft observed for an exchange at time t+1 is the market determined certainty equivalent of the future spot exchange rate st+1 (Fama 1984)." Eugene Fama conducted a study testing a model for measurement of both variation in the premium and the expected future spot rate components of forward rates. Assuming that the forward market is efficient or rational, the study found evidence that both components of forward rates vary through time. The study had two important conclusions. The first is that most of the variation in forward rates is due to the variation in the premiums and the second is that the premium and the expected future spot rate components of forward rates are negatively correlated. Fama utilized four equations to forecast the future spot rate. From the analysis of the standard deviation of forecast errors, the current spot rate is a better predictor of the future spot rate than the current forward rate. Also, in one of the equations utilized, the forward rate minus the spot rate (F-S), autocorrelation was present. However, since this autocorrelation decreases with larger lags, this suggests that there is only first-order correlation. Partial correlations were large at the first lag, but got closer to zero at higher order lags (Fama 1984). Thomas Chiang conducted a study developing a stochastic coefficient model to examine the UFH, proposing that "with effective use of information underlying the stochastic pattern of the estimated parameters in forecasting, it is possible to improve the accuracy of the exchange rate predictions (Chiang 1988)." Using data from the period January 1974 through August 1983, Chiang's study confirms the unbiased forward rate hypothesis for the markets studies (Canada, France, W. Germany, and UK). However, his study also found that, through use of the Brown-Durbin-Evans test and the Chow test, the constant coefficient hypothesis cannot be supported. He found that the constant term and the coefficient for the one-period lagged forward rate are subject to newly available information and vary through the sub-sample periods that he tested. Specifically, he found that when he tested sub-samples, in many cases, the constant term was significantly different from zero and the coefficient of the one-period lagged forward rate was significantly different from one. Therefore, whether or not the UFH held depended on the sample period chosen. Another interesting aspect of Chiang's study is that he added the two-period lagged forward rate as an independent variable in predicting the spot rate, and this variable was not found to be significant at the 5% level, suggesting that it "contains no significant increase in explanation for the spot rate (Chiang 1988)." Other studies have been conducted to determine the role that news plays in predicting the spot rate, because there was previously evidence that exchange rate movements respond to new information that is available to economic agents in every period. In other words, it has been suggested that the market forecasting error (the difference between the spot rate and the one-period lagged forward rate) is explained by the news captured in the spot rate that was not available when the forward rate was determined. Sebastian Edwards conducted an empirical study that examined the role that news plays in predicting the future spot rate. He found that in a world with more than two countries, the error terms in the standard market efficiency tests will be correlated, which means that the model displays serial correlation. Ultimately, his model found that the exchange rate could be "expressed as a function of factors known in advance--which are captured by the forward rate determined the in previous period--and 'news' regarding changes in domestic and foreign quantities of money, real incomes and real interest rates (Edwards 1982)." Edwards used a multi-currency approach and found that "The exchange rate market forecasting error can be expressed as a function of unanticipated changes in domestic and foreign quantities of money, real income and real interest rate and that in a multi-currency setting the error terms from the standard exchange-rate market efficiency tests will be correlated across currencies (Edwards 1982)." Edwards also found that using Zellner's seemingly unrelated regressions procedure (SUR) significantly improves the precision of the estimates. Despite the studies that place emphasis on the need for including a variable that measures news, some economists still feel that the current exchange rate includes all information needed to predict the future rate. "The international valuation of the currency will, then, generally show a tendency to anticipate events, so to speak, and becomes more an expression of the internal value the currency is expected to possess in a few months, or perhaps in a year's time (Cassel 1928)." "If the foreign exchange market is efficient and if the exchange rate is determined in a similar fashion to other asset prices, we should expect the behavior in that market to display characteristics similar to those displayed in other stock markets. In particular, we should expect that current prices reflect all available information, and that the residuals from the estimated regression should be serially uncorrelated

Proposed Methodology

Required Data: The required data for the proposed research is 3-month forward exchange rate of dollar rupee at 1 January of every year and spot exchange rate of dollar rupee at 1st April for the last ten years from 1998 to 2008 Availability of Data: The data is available from state bank of Pakistan library. Collection Methodology: The data will be collected on personal basis by visiting the central bank library. Testing Methodology: The data will be tested by applying the statistical test of correlation and if the correlation exist then we will apply the OLS regression test to test the hypothesis about the relationship between forward and spot exchange rate of dollar rupee Uses / Recommendation The result obtained from this research will be of great use in determining the effect of forward premium on the future spot rates

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