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Spot and Forward Exchange Rates: A Causality Analysis
Author(s) -
Callen Jeffrey L.,
Chan M. W. Luke,
Kwan Clarence C. Y.
Publication year - 1989
Publication title -
journal of business finance and accounting
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.282
H-Index - 77
eISSN - 1468-5957
pISSN - 0306-686X
DOI - 10.1111/j.1468-5957.1989.tb00007.x
Subject(s) - hebrew , wish , administration (probate law) , business as usual , management , library science , classics , political science , sociology , history , computer science , law , economics , anthropology
The purpose of this paper is to establish empirically the causality relationships between forward and spot exchange rates using the notion of Granger (1969) causality. Intuitively, spot rates cause forward rates in the sense of Granger if past spot rate information is useful in predicting future forward rates. Similarly, forward rates cause spot rates if past forward rates have predictive content with respect to future spot rates. The rationale for estimating the causality relationships between spot and forward exchange rates is twofold. First, there is an extensive literature in international finance which is concerned with predicting future exchange rates for exchange rates management purposes.' In the context of this literature, we want to see if causality analysis yields superior exchange rate predictions at least in comparison to standard univariate time-series analysis. Indeed, from the theory of exchange rate determination (see, for example, Grauer, Litzenberger and Stehle, 1976) we know that forward rates — or at least the current forward rate — contain information about future spot rates.^ Therefore, we should expect to find that forward rates cause spot rates.^ That is, forward rates are useful in predicting future spot rates. Second, there exists a related literature which is concerned with the efficiency of foreign exchange markets.* According to this literature, in an efficient market, the information conveyed by past spot rates should be fully impounded in future spot and forward rates. In particular then, spot rates should not prove useful in predicting forward rates, or alternatively, spot rates should not cause forward rates. The remainder of this paper is devoted to using causality analysis to examine these two issues empirically, namely, do forward rates cause spot rates and do spot rates not cause forward rates. The following section defines Granger causality more rigorously, and the third section introduces the models and procedures for determining causality relationships. The fourth section describes the data and empirical results. The final section concludes the paper.