Some forecasters believe that foreign exchange markets for the major floating currencies are "efficient" and forward exchange rates are unbiased predictors of future spot exchange rates
Explain the rationale of this statement including the assumptions made, the meaning of "efficient" and "unbiased", and the empirical evidence.
What will be an ideal response?
Answer: If the forward rate is an unbiased predictor of the future spot rate, the expected value of the future spot rate at time 2 equals the present forward rate for time 2 delivery, available now, E1(S2) = F1,2. Intuitively, this means that the distribution of possible actual spot rates in the future is centered on the forward rate. The fact that it is an unbiased predictor, however, does not mean that the future spot rate will actually be equal to what the forward rate predicts. Unbiased prediction simply means that the forward rate will, on average, overestimate and underestimate the actual future spot rate in equal frequency and degree. The forward rate may, in fact, never actually equal the future spot rate.
The rationale for this relationship is based on the hypothesis that the foreign exchange market is reasonably efficient. Market efficiency assumes that 1) All relevant information is quickly reflected in both the spot and forward exchange markets; 2) Transaction costs are low; and 3) Instruments denominated in different currencies are perfect substitutes for one another.
Empirical studies of the efficient foreign exchange market hypothesis have yielded conflicting results. Nevertheless, a consensus is developing that rejects the efficient market hypothesis. It appears that the forward rate is not an unbiased predictor of the future spot rate and that it does pay to use resources to attempt to forecast exchange rates.
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On November 12, Higgins, Inc., a U.S. Company, sold merchandise on credit to Kagome of Japan at a price of 1,500,000 yen. The exchange rate was $0.00837 on the date of sale. On December 31, when Higgins prepared its financial statements, the exchange rate was $0.00843. Kagome paid in full on January 12, when the exchange rate was $0.00861. On January 12, Higgins should prepare the following journal entry:
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