Essays on Foreign Exchange Market Efficiency and Risk Management Literature review

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The paper “ Foreign Exchange Market Efficiency and Risk Management” is a persuasive example of the literature review on management. An efficient market simply refers to a market whereby prices fully depict the available information. In the forex market, efficiency implies the presence of zero correlation in foreign exchange rate changes (Fama 1984, p. 320). Put differently, an efficient forex market is hypothesized to incorporate all information from the past exchange rates in the current exchange rates. According to Levich (1983, p. 49), fluctuations in exchange rates are common in foreign exchange markets, leading to uncertainties in the future exchange rates.

In many international trade dealings, a forward contract is used as an instrument for exchange rate risk management. A forward contract refers to a tailored contract between two parties to set an exchange rate for a business deal that will take place in the future (Levich 1983, p. 49). In an efficient foreign exchange market, investors are able to make rational expectations, from which they make predictions. A forward rate fixed by the trading parties is used as a forecaster for the prospective spot exchange rate.

In an inefficient forex market, the forward rate is a subjective forecaster of the spot exchange rate in the future. It is hypothesized that unlike in an efficient market, investors in an inefficient foreign exchange market are unable to make rational expectations and that they are able to enjoy returns for their investments. Extensive investigations have been conducted on whether the foreign exchange market is efficient or not. However, as Lee and Sodoikhuu (2012, p. 216) explain, economic analysts are currently undecided on whether the above facts should be interpreted to mean that the forex market is ineffective and hence, they do not reach the same conclusion on whether the forex market is effective or not.

This essay critically evaluates the supposition that the forex market is reasonably efficient and the rate of forwarding exchange is a strong determinant of exchange rate shifts and that the international business needs no additional exchange risk management systems.

References

Cavaglia, S M, Verschoor, W F, Wolff, C C 1994 ‘On the biasedness of forward foreign exchange rates: Irrationality or risk premium.’ Journal of Business, vol. 67, pp. 321–343.

Fama, E 1984, ‘Forward and spot exchange rates, Journal of Monetary Economics, vol. 14, no. 3, pp. 319-338.

Hakkio, C S 1981, ‘Expectations and the forward exchange rate’, International Economic Review, vol. 22, pp. 663–678.

Hopper, G P 1994, ‘Is the foreign exchange market inefficient?’ Business Review, accessed October 17, 2012, http://www.philadelphiafed.org/research-and-data/publications/business-review/1994/brmj94gh.pdf

Hsieh, D 1984, ‘Tests of rational expectations and no risk premium in forward exchange markets’, Journal of International Economics, Vol. 17, 173–184.

Lee, H & Sodoikhuu, K 2012, ‘Efficiency tests in foreign exchange market’ , International Journal of Economics and Financial Issues, Vol. 2, No. 2, 2012, pp. 216-224.

Levich, R M 1983, Empirical studies of exchange rates: Price behaviour, rate determination and market efficiency’, National Bureau of Economic Research, Working Paper No. 1112.

Levich, R M 2001, International financial markets, 2nd edition, McGraw-Hil, London.

MacDonald, R & Taylor, M P 1990a, ‘The term structure of forward foreign exchange rate premiums’, Manchester School of Economic and Social Studies, vol. 58, pp. 54–65.

MacDonald, R & Taylor, M P 1990b, ‘The monetary approach to the exchange rate: rational expectations, long-run equilibrium, and forecasting’, IMF Staff Papers, vol. 40, pp. 89–107.

Peel, D A & Pope, P F 1995, ‘Time-varying risk premia and the term structure of forward exchange rates’, Manchester School of Economic and Social Studies, vol. 63, pp. 69–81.

Salavatore, D 1993, International economics, MacMillan Publishing Company, New York.

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