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Estimating the structure and efficiency of the Canadian foreign exchange market : 1971-1978

University of British Columbia

After eight years under the Bretton Woods system, Canada returned to a regime of flexible exchange rates in May 1970. Over the remainder of the decade many other countries joined Canada in adopting flexible rates, and this movement has opened up a fertile new area for study by economists. This dissertation examines the Canadian foreign exchange market from several different points of view. It begins by comparing a number of theoretical models currently found in the literature, showing the common theoretical core from which the models are derived, as well as the differences among them. The models are then estimated using Canadian and U.S. quarterly data over the period 1971-78, and compared to one another on the basis of fit. The dissertation then turns to the question of prediction. Using the models discussed above, and time-series forecasts of the explanatory variables, monthly forecasts of three-month-ahead exchange rates are constructed for the period 1974-78. Care is taken to ensure that all forecasts are based only on information available to the market at the time the forecast was to have been made. The forecasts of the three-month-ahead exchange rate are compared to one another and also to the three-month forward rate, which is taken to be the market's forecast of the future value of the exchange rate. It is shown that the models' forecasts and the forward rate each contain separate information valuable in forecasting the future spot rate. The models and the forward rate are combined to produce a set of 'optimal' forecasts. The final chapter of the dissertation focuses on speculation and market efficiency. It is shown that the forecasts can be combined with a crude betting strategy to produce speculative profits over the sixty periods from 1974-78. No conventional measure of risk can be constructed, but it is shown that the probability of mean returns being negative after sixty bets is less than one percent. When transaction costs are taken into account, speculative returns are reduced, but the probability of average returns being negative after sixty bets remains less than one percent. Thus all of the estimated models appear to contain information that was not efficiently used by participants in the foreign exchange market between 1974 and 1978. Subsequent research will be required to tell whether this represents a learning period for market participants, or whether exchange market participants will continue to undervalue available information.

Text

2010-03-26

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http://hdl.handle.net/2429/22713

Economics

University of British Columbia

Graduate