SESSION TOPIC: CAPITAL ASSET PRICING IN INTERNATIONAL FINANCE

Abstract

THE RELATIONSHIP between forward foreign exchange rates and subsequent future spot rates has received extensive theoretical and empirical attention in the literature. Two hypotheses have been advanced on the theoretical side. The first hypothesis is that the forward rate is an unbiased estimate of the future spot rate. The second hypothesis holds that speculators in the foreign exchange markets require a return for assuming a speculative position and, hence, that the forward rate is not an unbiased estimate of the future spot rate. Several studies have attempted to test the empirical validity of the above hypotheses, but so far the results have been inconclusive. The basic proposition advanced and tested empirically in this paper is that a firm's (or an individual's) foreign exchange position must be analyzed within the context of the capital asset pricing model (CAPM). A summary of certain basic propositions in foreign exchange theory is given in Section II. The prior literature in the field is reviewed in Section III. Section IV develops the principal ideas of the paper. The precise nature of the risky asset represented by the foreign exchange commitment is identified and the asset's rate of return is specified in measurable form. In addition, the appropriate form of the empirical test is outlined. The results of the empirical tests are reported and analyzed in Section V. The conclusions of this study are that the forward rate is a biased predictor of the future spot rate and that speculative positions do not receive a return above that expected in the CAPM framework.