Participants in foreign exchange markets also deal for future values. Such dealing composes the forward markets or futures markets for currencies (Lu, 1997). Active forward markets exist for a few heavily traded currencies and for several time intervals corresponding to actively dealt maturities in the money market.
Risk management has been the traditional role of the futures markets. Traders, as an example, use currency futures to protect (hedge) themselves against fluctuations in exchange rates that may be detrimental to their profit margins. A United States trader who needs foreign currency for a business transaction in six months could sell a futures foreign currency contract for the same amount maturing in six months. If after six months the United States dollar depreciated relative to the foreign currency, the trader would incur losses in the spot market, but gains from the futures contract offset those losses exactly. On the other hand, if the dollar appreciated relative to the foreign currency, the trader would incur losses in the futures market that would exactly offset gains in the spot market. Thus, in a typical hedge, the gains or losses tend to offset each other (Kapila & Hendrickson, 2001).
Participants in currency the futures market require some method of projecting currency exchange rates. Although there exist many models to forecast and manage foreign exchange rate changes, three models have demonstrated staying power. These models are the purchasing power parity model, the current account balance model, and the portfolio balance model. Additionally, the random walk model and the international Fischer effect model have gained some degree of acceptance. The following discussions review these models for the projection of currency exchange rates.
A Review of Models for the Prediction of Forward Currency Values
Of the many models developed to forecast and manage foreign exchange rate changes, three m...