The Theory of Forward Exchange and Effects of Government Intervention on the Forward Exchange Market Author(s): S. C. Tsiang Reviewed work(s): Source: Staff Papers - International Monetary Fund, Vol. 7, No. 1 (Apr., 1959), pp. 75-106 Published by: Palgrave Macmillan Journals on behalf of the International Monetary Fund Stable URL: http://www.jstor.org/stable/3866124 . Accessed: 14/11/2012 22:10 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp . JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact [email protected]. Palgrave Macmillan Journals and International Monetary Fund are collaborating with JSTOR to digitize, preserve and extend access to Staff Papers - International Monetary Fund. http://www.jstor.org This content downloaded by the authorized user from 192.168.52.68 on Wed, 14 Nov 2012 22:10:02 PM All use subject to JSTOR Terms and Conditions The Theoryof ForwardExchange and Effectsof GovernmentIntervention on the ForwardExchange Market S.C. Tsiang* THE THEORY OF FORWARD EXCHANGE badly needs a sys- tematicreformulation. Traditionally, the emphasishas always been upon coveredinterest arbitrage, which formsthe basis of the so-called interestparity theory of forwardexchange.1 Modern economists,of course,recognize that operationsother than interestarbitrage, such as hedgingand speculation,also exert a determininginfluence upon the forwardexchange rate,2 but a systematictheory of forwardexchange whichexplains precisely how the interplayof all thesedifferent types of operationjointly determinethe forwardexchange rate and how the forwardexchange market is linked to the spot exchange market still appears to be lacking. The purposeof this paper is to workout a more comprehensiveand systematictheory of forwardexchange, which would enable us betterto understandthe behavior of the forwardexchange rate and to deduce the likely consequences of governmentintervention in the forward exchangemarket. * Mr. Tsiang,economist in the Special Studies Division, is a graduateof the London School of Economics,and was formerlyProfessor of Economicsin the National PekingUniversity and the National Taiwan University.He is the au- thorof The Variationsof Real Wages and ProfitMargins in Relation to Trade Cycles and of severalarticles in economicjournals. 1 See, e.g., HenryDeutsch, Transactions in ForeignExchanges (London, 1914), p. 174,and J.M. Keynes,Tract on MonetaryReform (London, 1923), pp. 122-32. 2 See Keynes,op. cit.; P. Einzig, The Theoryof ForwardExchange (London, 1937); League of Nations, Economic IntelligenceService, MonetaryReviews (Geneva, 1937), Section B, "The Market in Forward Exchanges."pp. 42-51; C.P. Kindleberger,"Speculation and Forward Exchange,"Journal of Political Economy,Vol. XLVII (April 1939), pp. 163-81,and InternationalEconomnics (Homewood,Illinois, 1953), Chap. 3, pp. 39-57; F.A. Southard,Jr., Foreign Ex- changePractice and Policy (New York,1940), Chap. III, pp. 75-111; A.I. Bloom- field,Capital Importsand the AmericanBalance of Payments,1934-1939 (Chi- cago, 1950), Chap. II, pp. 39-85; J.E. Meade, The Theory of International EconomicPolicy, Vol. 1, The Balance of Payments(London, 1951),Chap. XVII; J. Spraos,"The Theoryof ForwardExchange and Recent Practice,"The Man- chesterSchool of Economicand Social Studies,Vol. XXI (May 1953),pp. 87-117; and M.N. Trued, "InterestArbitrage, Exchange Rates, and Dollar Reserves," The Journalof Political Economy,Vol. LXV (October 1957), pp. 403-11. 75 This content downloaded by the authorized user from 192.168.52.68 on Wed, 14 Nov 2012 22:10:02 PM All use subject to JSTOR Terms and Conditions 76 INTERNATIONAL MONETARY FUND STAFF PAPERS Some Definitions In this paper, the exchangerate will be expressedas the price of a unit of a given foreigncurrency in termsof local currency.Similarly, the forwardexchange rate will be expressedas the unit price in local currencyof foreignexchange bought or sold for futuredelivery. For- ward premium(or discountwhen negative) is to be understoodas the discrepancybetween the forwardand spot exchange rates as a per- centageof the spot exchangerate. In normal circumstances,the forwardexchange rate is determined by threemain typesof operation: 1. Hedgingin connectionwith foreign trade. This typeof operation arises out of the normal desire of merchantswho trade with foreign countriesto insurethemselves against the risk of exchangefluctuation affectingtheir currenttransactions, which are normally contracted monthsbefore the paymentsor receipts involvingforeign currencies become due. The contractedamount of paymentor receiptin foreign currencycan be transformedimmediately into an obligationor a claim fixedin one's own currencyby means of a purchaseor sale of forward exchangeof the same amount. 2. Speculation. Speculationmay be definedin a narrowsense and a wide sense.In the narrowsense, speculation in forwardexchange means any sale or purchasewhich results in the deliberateincurrence of addi- tional risks of exchangeuncertainty on the part of the operator-i.e., it increases the net open position (long or short)3 of the operator- with a view to profitingfrom the discrepancybetween the currentfor- ward rate and the probablefuture spot rate thatthe operatorexpects to prevail.Speculation in this narrowsense is to be contrastedwith "hedg- ing,"which is definedas a sale or purchaseof forwardexchange calcu- lated to reduce the pre-existingexchange risks of the operator-i.e., it covers (or reduces) his originalopen position.In this narrowsense, a professionalspeculator who closes somewhathis excessive open (long or short) positionbecause of a change in his expectationsas to future spot rates or a change in the currentforward rate must be regarded as a hedgerperforming a hedgingoperation. On the otherhand, a mer- chant who chooses to hedge only a part of his exchangecommitment, because the currentforward rate is too high (or too low) in relationto the futurespot rate whichhe expects,cannot be regardedas speculating 3 As defined by Professor Kindleberger, an excess of uncovered claims over liabilities in foreignexchange is called a "long position"; an excess of debts over assets, a "short position." See Kindleberger, International Economics (cited in footnote 2), p. 40. This content downloaded by the authorized user from 192.168.52.68 on Wed, 14 Nov 2012 22:10:02 PM All use subject to JSTOR Terms and Conditions THE THEORY OF FORWARD EXCHANGE 77 at all, even thoughhis decisionnot to hedgeis essentiallysimilar to that of a speculatorwho takes a chance in incurringan open position. In a wide sense,speculation may be definedas the deliberateassump- tion or retentionof a net open (long or short) positionin foreignex- changeupon considerationof the currentforward rate and the probable futurespot rate whichthe operatorconcerned expects to prevail. Under this broad definition,a merchantwho fails to hedge to the full extent ofhis net exchangecommitment is, to a certainextent, speculating. This wider definitionis the more convenient,since merchantswho deliber- ately leave parts oftheir commitments unhedged are essentiallymaking the same type of decision as professionalspeculators who deliberately assume risky commitments(open positions); consequently,the two actions can be analyzed in the same way. When speculationis definedin this wide sense, however,we must assume that merchants,acting as hedgers,automatically hedge to the full extentagainst theirexchange commitments by purchasesor sales of forwardexchange unless the exchangerisks are alreadyeliminated by otherarrangements. If some of themdo in fact leave part of theirrisky commitmentsunhedged, we shall treatthem as if they,this time acting as speculators,have reassumednet open positionsby oppositeforward transactions,offsetting part of the forwardpurchases or sales with which they have supposedlyhedged themselvesagainst all exchange risks in their originalcommitments that may arise out of theirtrade transactions. 3. Coveredinterest arbitrage. Short-term funds have a naturaltend- ency to flow fromone countryto another in search of the highest returns.Through the mechanismof the forwardexchange market, such search forthe highestreturns can be divorcedof any speculative ex- change risk; that is, the person (or institution)that transfersfunds fromone countryto anotherin search of higherreturns on investment can coverhis spot exchangetransactions by forwardtransactions in the opposite directionand thus avoid assumingany net open position in foreignexchange. Covered interestarbitrage may thus be definedas an internationaltransfer of spot funds for short-terminvestment pur- poses covered by a simultaneousforward transaction of the same amountin the oppositedirection. Such an operationleaves the net posi- tion and exchangerisk of the operatorunchanged, which is the essen- tial featurethat differentiatesit fromboth hedging and speculation. Normally,these threetypes of operationare likely to be performed by differentgroups of people or institutions;however, not infrequently the same person or institutionmay performmore than one type of operation at the same time. Commercialhedging (in the automatic This content downloaded by the authorized user from 192.168.52.68