FREE online courses on Investment Decisions in Exchange Rates - The Expectations Theory Applied to Exchange Rates

 

The Expectations theory argues that the forward rates quoted in the market for foreign exchange are useful in forecasting future exchange rates.  In particular, the Expectations theory argues that forward rates are exactly equal to the spot exchange rate that is expected on the delivery date specified in the forward contract (30, 60, 90 or 180 days in the future).  Thus, the Expectations theory implies that the forward exchange rates quoted in the foreign exchange market are unbiased forecasts of the exchange rates the are expected in the future.  While the exact economic circumstances under which the Expectations theory holds are complex to describe, empirical evidence suggests that the Expectations theory is a fairly good description of the true relation between forward exchange rates and expected future exchange rates.

 

The Expectations theory implies that the cost of hedging exchange rate risk is costless.  Consider the following alternatives for hedging exchange rate risk:

 

1          Always invoice in dollars

 

Although invoicing in dollars completely avoids losses (and gains) attributable to fluctuations of the value of foreign currency relative to the dollar, a refusal to invoice in a foreign customer's own currency may result in a loss of sales to competitors willing to invoice in the the customer's own currency.

 

 

2          Selling foreign currency forward

 

This alternative is desirable to the extent that exchange rate risk is eliminated.  However, selling anticipated receivables denominated in foreign currencies in the forward market is costly whenever the forward rate differs systematically from the spot exchange rate that is expected to prevail when the receivable is scheduled to be collected.  Therefore, the cost of the “insurance” obtained by selling currency in the forward market is the difference between the forward rate, F, and the expected spot rate, E(S).  If the expectations theory holds (i.e., forward rates are always equal to the expected spot rate), then the cost of hedging (insuring against) the risk of fluctuations in exchange rates is zero.  In practice, differences between forward rates and actual future spot rates are small on average.