A new monetary model of foreign exchange rates

Abstract

An attempt is made to create a model of exchange rates that explains the short term, daily levels of the foreign exchange spot market. The model is a monetary type that focuses on the eurocurrency markets and the current account. It has a liquidity preference form and employs daily data. The futures rate, the euro interest rate, the eurocurrency money stocks and a current account variable are the individual variables of the model. The futures rate and the euro interest rates are from the assumed Fisher's 'Covered Interest Rate Paradigm'. The eurocurrency money stock variable's justification is based on the real world structure of the spot market where the foreign exchange desks of the major world commercial banks are the dominant players. The current account variable, which is motivated by a desire to improve on the short run performance of the Purchasing Power Parity variable of other monetary models, is justified by trade theory. The liquidity preference form of the model is in keeping with current monetary models. The econometric results show that the model is better than the random walk model. However the results of the individual variables are mixed. The futures rate accounts for the vast majority of the model's success. Although the eurocurrency variable is as statistically significant as the interest rate differentials from the widely accepted Fisher's Covered Interest Rate Parity paradigm, neither was as significant as the futures rate. The current account variable results are not statistically significant. Thus, the current account variable may be discarded while the eurocurrency interest rates and euromoney variables warrant further study. As a result of the dominance of the futures rate variable, models that cry to capture rational expectations such as the News or Chaos Models are appealing. This rational expectations characteristic of the market combined with the dominance of speculation over economic fundamentals also points toward game theory as a good candidate for further study.