University of Oulu

Persistence and predictability of forward exchange arbitrage in managed rate currencies in comparison to free-floating currencies

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Author: Jayasundera, Thanushka1
Organizations: 1University of Oulu, Oulu Business School, Department of Finance, Finance
Format: ebook
Version: published version
Access: open
Online Access: PDF Full Text (PDF, 1.9 MB)
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Language: English
Published: Oulu : T. Jayasundera, 2014
Publish Date: 2014-06-17
Thesis type: Master's thesis
Tutor: Kahra, Hannu
Reviewer: Perttunen, Jukka
Kahra, Hannu
This paper attempts to analyse whether forward exchange arbitrage in currencies of managed rate regimes behave differently from currencies of free floating regimes in the forward exchange market. For this purpose, currencies of Great Britain, the European Union, and Japan are used as proxy currencies for free floating currencies. Proxy currencies for managed rate currencies are the Sri Lankan Rupee, the Indian Rupee, the Russian Rouble and the Brazilian Real. The US dollar is used as the anchor currency for both sets of currencies. The core of the paper revolves around the pricing difference between the fundamental forward price and the market forward price. Fundamental forward price is calculated based on the interest rate differentials of the two currencies; this is in concurrence with the interest rate parity condition. Market price is based on the forward pips and the spot rate. This analysis concentrates on the persistence of mispricing availability, the availability of forward pricing differences and the predictability of the mispricing in both sets of currencies. Finally, we also test whether the current forward price can predict the future spot price based on the interest rate parity theory. We present evidence that almost all the currencies have forward rate mispricing. However, we also present evidence to prove that mispricing in free floating currencies is extremely small, while managed rate currencies offer significant mispricing that could be exploited for arbitrage purposes. We also present evidence to establish that persistence of mispricing is specific to the currency pair and cannot be clearly attributed to the exchange rate regime. This paper also finds that it is not possible to statistically forecast the mispricing in both free floating and managed rate currencies. Further, failure of interest rate parity theory to accurately forecast the future spot rate is also documented.
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Copyright information: © Thanushka Jayasundera, 2014. This publication is copyrighted. You may download, display and print it for your own personal use. Commercial use is prohibited.