The reaction of spot and forward rates to new information

European Economic Review 30 (1986) 305-324. North-Holland

THE REACTION OF SPOT AND FORWARD RATES TO NEW INFORMATION* John DOUKAS Concordia

University, Montreal,

Que., Canada,

H3G

1MB

Melhem MELHEM International

Monetary

Fund,

Washington,

DC 20431,

USA

Received May 1985, fmal version received November 1985 This paper examines the impact of new information on the term structure of exchange rates. In particular, the response of spot and forward exchange rates to anticipated and unanticipated weekly U.S. and Canadian money growth announcements, and the speed of adjustment of the foreign exchange market to these announcements are investigated. The results indicate that the unanticipated component of the announced changes in the U.S. money supply has an immediate negative effect on the foreign vahre of the U.S. dollar. This is entirely consistent with the assetmarket theory of exchange rate determination that postulates that exchange rates immediately adjust to reflect ‘new information’. The response of the forward market, however, appears to be weaker, lending support to the overshooting hypothesis.

1. Introduction Understanding the workings of the foreign exchange market is one of the major tasks before international financial economists. How one understands this market to work will determine the advice given to both the private and public sectors as to how to conduct themselves in a system of marketdetermined exchange rates. Looking at the totality of our experience with floating exchange rates, one may observe that bilateral exchange rates have widely fluctuated and over short intervals of time have been more volatile than their underlying fundamental economic determinants. There is no concensus on how exchange rates are determined and why they have exhibited increased volatility lately. The interpretations vary widely among the various theories, ranging from the flow-market approach to the modern asset-market mechanism and expectations. The asset-market approach to the analysis of exchange rate behavior views the exchange rate as the relative *The views expressed in this paper are ‘the authors’ and do not necessarily reflect views of the International Monetary Fund. 00142921/86/$3.50

0 1986, Elsevier Science Publishers B.V. (North-Holland)

306

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and M. Melhem,

Spot and forward

rates reaction

to new information

price of two national assets (currencies), rather than the relative price of different national outputs, determined by the demand for and supply of the stocks of various national currencies and the requirement that the existing stocks of the two national currencies are willingly held. Furthermore, the asset-market theory of exchange rate determination recognizes different speeds of adjustment between the assets and goods market, and the central role of exchange rate expectations in influencing exchange rates. This approach implies that exchange rates move randomly in response to new information that alters the expectations of the market about conditions that could influence exchange rates. Consequently, when the market is dominated by ‘news’ that modify expectations, exchange rates are likely to be more volatile than other economic variables. Empirical evidence, concentrated on the forecasting ability of the forward exchange rate, is inconclusive as to whether or not the foreign exchange markets have been efficient during the present system of floating exchange rates [Levich (1979a, b), Mussa (1979)]. This paper proposes to develop a methodology, consistent with the asset-market models and rational expectations-efficient markets, to explore the pattern of the term structure of foreign exchange rates around money supply announcements and to determine if the volatility exhibited by exchange rates is the result of efficient market conditions prevailing in the foreign exchange markets. Thus the objective of this paper is to investigate the response of spot, one-month, three-month and six-month exchange rates to the information (‘news’) content of weekly money supply announcements over the course of the 1970s. Concentration on the term structure of foreign exchange rates will also permit us to investigate whether or not spot and forward rates respond differently to these money supply innovations. Samuelson (1965) has theoretically shown that futures prices become increasingly volatile as a contract approaches the delivery period. In other words, the prices of short-term futures contracts are more volatile than the prices of long-term forward contracts. This short-run price response that exceeds the long-run response Levich (1981) defines as foreign exchange rate overshooting. In this paper the overshooting hypothesis will be tested in Levi&s (1981) sense; that is, examine whether forward exchange rates are less responsive than spot rates to weekly monetary shocks. Such a test would also shed some light regarding the validity of the law of increasing price volatility, derived by Samuelson (1965), using a model of futures price formation, in the context of the foreign exchange market. The paper is organized as follows. The next section presents the methodology and the weekly money supply process is discussed. Section 3 presents the results of the tests. The Money Market Services data are presented in section 4 and the analysis of section 3 is repeated. The main conclusions of this study are summarized in the final section.

J. Doukas

and M. Melhem,

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rates reaction

to new information

307

2. Weekly money supply announcements and methodology It has recently been suggested by Dornbusch (1980) and Frenkel (1981a, b), among others, that exchange rates movements basically respond to new information that is made available to economic agents in every period. Consequently any increase in the expected money supply would have been anticipated earlier and would have no effect on the exchange rate movement immediately surrounding the money supply announcement. Thus, any movements in the exchange rate immediately following the announcement should be due to the unanticipated component of the money supply. That is, observed exchange rate fluctuations immediately after the money supply announcements essentially reflect that the unanticipated component of the money supply contains new information. This suggests, a straightforward test of the effect of unanticipated money supply and the asset-view of exchange rate determination hypothesis by estimating the following equation:

where S, is the spot exchange rate on Friday at 10.00 a.m. (after the announcement of money supply figures), S,, is the spot exchange rate on Thursday at 10.00 a.m. (before the announcement), 112, is the anticipated money supply component derived from the ARIMA model (fitted value), & is the unanticipated money supply component derived from the ARIMA model (error term), and u, is the well behaved error term (mean 0, variance o,“, and zero serial correlation). All the variables in the above model are . expressed in logarithmic form. Under the asset-view of exchange rate determination hypothesis, b, =0 and b2 #O if the money supply announcements do contain new important information. Furthermore, b2 is expected to be between (- 1~ bz ~0) if positive money supply errors tend to be reversed in the next periods. Much of the recent literature has been concerned with observed greater volatility in exchange rates relative to goods prices. The asset-market approach to the analysis of exchange rate behavior maintains the hypothesis that the exchange rate, being a relative price of two assets, is determined by essentially the same ‘forces that determine the prices of other assets that are traded in organized asset markets [see Dornbusch (1976), Mussa (1979)], such as the stock markets and the commodity exchanges. In such markets the pricing of assets (durable items) is based on the concept of stock equilibrium. As a result, asset prices will be such that market participants, following their optimal strategies, are willing to hold the outstanding supply of each stock and to absorb the full amount of each new issue. Thus the current price of an asset is directly associated to the market’s expectation of the future price of that asset. Consequently if the market is efficient we would

308

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and M. Melhem,

Spot andforward

rates reaction

to new information

expect information to be rapidly incorporated into prices [Fama (1970)]. Hence new information contained in the weekly money supply announcements (money supply innovations) should be reflected in the exchange rate. This would imply that exchange rates adjust quickly to ‘fully reflect’ all new publicly available information. Whenever information is not quickly incorporated into the exchange rate, there will exist an opportunity for economic agents to develop profitable trading rules based on this information. To determine whether the market has used the information contained in the weekly money supply announcement by Friday 10.00 a.m. the following equation is estimated: (2)

where SM is the spot exchange rate on Monday at 10.00 a.m., SF is the spot rate on Friday at 10.00 a.m. All other variables are the same as in eq. (1) and in logarithmic form. Similarly, under the asset-view of exchange rate determination and the efficient market hypothesis, bl =0 since all expected money supply change has already been discounted by market participants. As for b2, if the market has not completely used information contained in the unexpected component of the announcement by 10.00 a.m. on Friday, then bz#O and there is a potential for above-normal profits to be made by investors who trade using this information, On the other hand, if the information is completely used, by Friday at 10.00, then b2 =0 and such a speed of adjustment would be indicative of an efficient foreign exchange market. Turning to the forward exchange market’s response to weekly money supply announcements the tests are performed by estimating the following equation: (3)

where FF,, is the n-period forward exchange rate on Friday at 10.00 a.m., F TH,” is the n-period forward exchange rate on Thursday at 10.00 a.m., while all other variables are the same as in eqs. (1) and (2). Once again, it is hypothesized that only the unanticipated movements of monetary growth, %, affect forward exchange rates immediately after the announcement. However, as shown by Samuelson (1965), it is expected that the response (variability) of short-term forward contracts to be greater than that of long-term forward contracts immediately after the weekly money stock announcements. Samuelson’s explanation of such contract maturity variability phenomenon is dependent on the fact that the spot price tends to return to its mean value and that the current forward price is equal to the expected future spot price. Thus,, although prices are free to vary in the short

.I. Doukas

and M. Melhem,

Spot and forward

rates reaction

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309

run, in the future they appear to be nailed down. Levich (1981), on the other hand, defines this exchange rate pattern as foreign exchange rate overshooting. Consequently, we would expect the effect of the unanticipated money supply (m,) to be larger on the spot rate, than on the forward rate. To empirically test for the asset-view of exchange rate determination hypothesis (i.e., the effect of the new information content of money supply announcements on exchange rates) over the 1975-1978 floating period, it is necessary to decompose the observed monetary growth into its anticipated and unanticipated components. The anticipated money supply is taken as the value that could be obtained by exploiting the systematic component of the money supply series. More specifically, a time series model (ARIMA) of the money supply is estimated from the .data and the fitted values from the model are taken as the expected (anticipated) component of the money supply while the residuals are taken as the unexpected (unanticipated) component. A similar technique for separating monetary growth into its expected and unexpected components has been used by Urich and Wachtel (1981), and Cornell (1983a,b) as well. A more appropriate approach would require the recognition of other structural variables and relationships since they may play an important role on determining the future growth of the money supply [see Barro (1977)]. However, ARIMA model estimates have been used extensively and as Urich and Wachtel have stated ‘by this time, ARIMA model estimates can be treated as a standard methodology for proxying anticipations’. These arguments, coupled with the fact that we are using weekly money supply data and on a week to week basis few structural changes occur, provide us with enough confidence in using money supply data as the only determinant of the future monetary growth. ’ Examination of the data and estimations indicated that the money supply series can be adequately described by an autoregressive-integrated movingaverage model (ARIMA) for all the sample periods described by the following equations:’ U,u’=

0.001065 - 0.95981/,-r (18.6680) (- 11.6935) -O.O2645e,-, (-0.3853)

+ 0.9360e,-, (15.5448)

+ 0.7734U,-2 (0.8144)

+ 0.4288U,-3 (0.6407)

-.O.O2462e,-,,, (-0.5245)

where U, = lnM, - lnM,- i (t-statistics in parentheses). The Box-Pierce statistic for 40 lags on the residual autocorrelation function is equal to 3.708 which indicates that the hypothesis that the ‘For a detailed explanation of the technique used here, see Box and Jenkins (1970).

310

J. Doukas

and M. Melhem,

residuals are a significance. Estimation of be estimated by by the following UFAN=

Spot and forward

rates reaction

to new information

white noise process cannot be rejected at the 5% level of the Canadian money supply data shows that the series can an autoregressive moving-average model (ARIMA) described equation:

0.001956 - O.O08992U,-i (15.2100) (0.1025) + 0.09419U,-26 (1.4208)

+

+ 0.4860e,-, (4.3627)

O.6757U,-2 + 0.6529U,-,3 (11.4332) (-9.7158) - 0.5032e,-, - 0.7649e,-,,. (4.6208) (-40.4495)

The Box-Pierce statistic for 40 lags on the residual autocorrelation function is equal to 35.830 which indicates that the hypothesis that the residuals are a white noise process cannot be rejected at the 5% level of significance. Alternatively, another approach would be to use expectational money supply data. Expectational data should be employed in empirical tests of eqs. (l)-(3) not only because the asset-market exchange rate determination models are inherently ex ante in nature, but also to avoid the potential estimation errors involved in the expectations (forecasts) obtained from ARIMA time-series models. In an effort to deal with desirability of obtaining market-based expectational money supply data, ex ante data are drawn from the Money Market Services survey. Unfortunately, the Money Market Services started to survey money market traders and economists September 1977. Nevertheless, estimation of eqs. (l)-(3) based on the Money Market Services’ anticipated (forecast) and unanticipated (error) money supply changes for the period after September 21, 1977 can be carried out. This would also allow us to compare the results obtained from the Box-Jenkins time series estimations. In the mid 1970s both the Federal Open Market Committee (FOMC) and the Bank of Canada started to formulate monetary policy in terms of target ranges for the growth rates of different monetary aggregates. Weekly money supply figures were announced on Thursday afternoons both in the U.S. and Canada. These announcements are the preliminary estimates of the money supply for the week ending Wednesday eight days before. The money supply measure used here is the ‘old MI’ as first announced on Thursday at 4.10 p.m., EST. The MI data for the U.S. were obtained from the Federal . Reserve Statistical Release H.6. The U.S. money stock data we used are seasonally adjusted. The money stock (MI) data for Canada were obtained from the Bank of Canada weekly financial statistics release. The Canadian money stock data are not seasonally adjusted.’ ‘Bank of Canada does not report seasonally adjusted Ml

figures.

.I. Doukas

and M. Melhem,

Spot and forward

rates reaction to new information

311

The exchange rate data series (U.S.$/CAN$ and U.S.$/DM) were obtained from DRI and they consist of daily observations of the spot, one-month, three-month and six-month exchange rates at 10.00 a.m. We have used the bid data because it was the more complete set. The models specified in eqs. (l), (2) and (3) are estimated using data spanning the period from January 1, 1974 to October 3, 1979 mainly because the money supply (MI) became very controversial as to what it represented and whether it should be continued to be used in the old form. 3. Empirical results Using the term structure of Canada’s and the West Germany’s foreign exchange vis-a-vis the United States, the various models described above were estimated using OLS on a yearly basis from 1974 to 1979. This section will first present the response of spot exchange rates to money supply announcements and results on market efficiency (market’s speed of adjustment of these announcements), then the response of one-month, three-month and six-month forward exchange rates to money innovations is expected to throw some light on the law of increasing price volatility and on the structure of the foreign exchange market as a whole. 3.1. Spot exchange rates and the information content of money supply announcements

Empirical results based on eq. (1) using both U.S. and Canadian anticipated and unanticipated components of money stocks,3 as shown in table 1, indicate that the effect of the unanticipated component of the’U.S. money stock, bl, on the exchange rate is greater than any of the effects of the other explanatory variables. As for the significance of bz versus the other variables, the results indicate that the hypothesis that only unanticipated money stock changes affect the movement in the $/C$ spot exchange rate cannot be rejected at the 5% confidence level. During the mid 197Os, the FOMC formulated monetary policy in terms of target ranges for the growth ratio of MI and M2, the Fed Funds rate as well as other variables. Because of Fed’s mixed operating procedure and the downward money demand shift in 1974, an unanticipated money supply change would be difficult for market participants to interpret and consequently their response would be smaller which is reflected in the size of b2 in 1974 and 1975. On the other hand, the observed insignificance of &‘” in 1978 and its positive relationship with the change in the exchange rate (dollar devaluation) can be attributed to the large intervention in the exchange markets by the U.S. government and the “When eq. (1) is estimated using only the U.S. money supply components we obtain similar results as those presented in table 1.

50

49

195

49

40

138

1976 no. of obs:

1977 no. of obs:

1974-1977 no. of obs:

1978 no. of obs:

1979 no. of obs:

1977-1979 no. of obs:

-3.7493E-04. (-1.864)

-4.2511E-04 (-0.352)

-9.3646E-05 (-0.165)

- 3.6069~04b (-1.857)

4.0055E-05 . ( - 0.099) -4.4781~04 (-1.010)

1

(-

- 3.046833-02 1.122)

- 1.8452E-02 (-1.004)

- 3.37OOE-03 (-0.406)

- 3.594OE-02 (-1.145)

- 2.69OOE03 ( - 0.084)

- 1.8004E-02 (-0.851)

- 2.0465E-O18 (-1.946) -4.2680E-02b (-2.027)

- 1.9786E-02 (-0.567)

3.4490E-02 (0.835)

- 1.8630E-02 (-1.097) - 1.647oLO4 (-0.017)

- 1.5572E-01’ 1.897) - 7.1096E-02b (-2.156)

(-

- 1.3283E-018 1.826)

(-

3.7697E-03 (-1.726)

- 1.0701EOl’ (-1.715)

-2.4651E-03 (-0.152)

-9.7051B02 (-1.481)

-4.755E3-03 (-0.083) - 1.8907E-03 (-0.130)

1.3482E-03 (0.028) 3.2339E-02 (0.589)

h

-4.1384E-02 ( - 0.720)

coefficients

2.3677E-04 (-0.832)

-6.7233EAMb (-2.321)

constant

Estimated

Table

3.0862E-03 ww

1.9370E-02 (0.920)

5.8415E-03 (0.307)

2.9809E03 (0.428)

1.3865E02 (0.779)

1.4679E-02 (1.057)

- 1.19OlE02 (-1.211)

- 5.9322E-03 (-0.449)

b,

and

0.0358

0.0431

0.0440

0.0265

0.0396

0.0718

0.0878

0.0089

RZ

Summary statistics

to Friday changes in the spot ($/C$) exchange rate weekly money supplies (r-statistics in parentheses):

Sp-Snr=b,+b,rqus+b,~s+b*~~N+b~~AN+u,.

on the relation between Thursday Canadian anticipated and unanticipated

at the 10% level. at the 5% level.

49

1975 no. of obs:

‘Significant bSigniIicant

47

evidence

1974 no. of obs:

Estimated period

Empirical

and

1.8203

1.8015

2.3120

1.7966

1.7168

2.1391

1.7033

2.0003

D-w

U.S.

313

J. Doukas and M. Melhetn, Spot and forward rates reaction to new information

increased uncertainty about Fed’s monetary policy as the FOMC began to place more emphasis on money market conditions and less on the monetary aggregates during this period. What is of more interest is that the coefficient of the stochastic component of the U.S. money stock variable was negative in 1974, 1975, 1976, 1977 and 1979 which implies that an unanticipated increase in the US. money supply led to an appreciation of the U.S. dollar in the very short run. When the equation was re-estimated using data from 19741977 and 1977-1979 the only coefficient that was significant at the 5% confidence level was again the stochastic component of the U.S. monetary growth. Results from the spot $/DM equation presented in table 2 show that the relationship between unanticipated U.S. money supply and $/DM exchange rate changes, with the exception of 1978 again, was negative and statistically significant for 1976, 1977 and 1979 at the lo%, 5% and 5% significance level, respectively. While for the 1974-1977 period the coefficient of ds is larger Table 2 Empirical evidence on the relation between Thursday to Friday changes in the spot (SjDM) exchange rate and the U.S. anticipated and unanticipated weekly money supplies (t-statistics in parentheses): SF-ST,,= b,+ bids+

b,Gs +u. Summary statistics

Estimated coefficients Estimated period 1974 no. of obs: 1975 no. of obs: 1976 no. of obs: 1977 no. of obs: 1974-1977 no. of obs: 1978 no. of obs: 1979 no. of obs: 1971-1979 no. of obs:

Constant 41 49 50 49 195 49 39 127

h

1.2348E-03’ 1.4450E-01 (1.518) (0.988) -8.5564E-04 2.4075E-02 (- 1.391) (0.172) - 1.5898E-03b 4.0357E-02 (-2.859) (0.480) - 1.3987E-Ola 2.5087E-04 (0.565) (-1.731) - l.O031E-04 1.3487B02 ( - 0.342) (-0.234) 2.569E-03 -2.0087E-04 (0.155) (-0.188) - 1.2028E-02 - 1.4425E-04 (-0.124) (-0.165) - 3.0026E-04 - 2.0970E-U3 (-0.105) (-0.420)

“Significant at the 10% level. bSignificant at the 5% level.

- 3.4941B02 (-0.214) -9.71$6E-02 (-0.666) - 1.6284E-Olb (-2.030) - 1.5777E-01’ ( - 1.803) -7.7031E-02 (- 1.286) 7.274-03 (0.096) -1.82OOE-Olb ( - 2.004) -3.5820E-02’ (- 1.840)

.R2

D-w

0.0459

21714

0.0255

2.2752

0.1644

1.7003

0.0733

2.0986

0.0136

2.1000

0.0008

1.1476

0.0205

1.7628

0.0360

2.0070

314

J. Doukas and M. Melhem, Spot andforward rates reaction to new information

than the t-values of the other variables it is only significant over the 19771979 period.4 Furthermore, the relatively low i?‘s confirm the basic result of the asset-market approach; that is, most of the variance of exchange rate movements is due to unexpected events [Mussa (1979, Frenkel(1981a, b)]. In general, these results combined with the findings reported by Grossman (1981), and Urich and Wachtel (1981) regarding the relationship between unexpected changes in the U.S. money supply and changes in interest rates over the same period provide empirical support for the policy anticipation effect [see Urich and Wachtel (1981)]. Furthermore, our results also lend support to Dornbusch’s (1976a, b, c) model of short-run exchange rate behavior. In his study Cornell (1982) using five exchange rates over the period from October 1979 to December 1981 finds similar results to those reported in tables 1 and 2. Recently, Engel and Frankel (1984) examined the mark exchange rate response to unanticipated money supply changes for the post-October period. They found too a negative and statistically significant relationship between the two variables, though the coefficient of the unanticipated money variable and t-statistic are slightly higher. This implies, as anticipated, that the policy anticipation effect has a stronger impact on exchange rates during periods when the Fed places more emphasis on monetary aggregates and less on money market conditions. 3.2. Tests of speeds of adjustment

To test whether the foreign exchange market is efficient in the sense that all information contained in the weekly money supply announcement is used by Friday at 10.00 a.m. we estimate eq. (2). If all information in the money supply announcement is incorporated by Friday at 10.00 a.m. then both coefficients of anticipated and unanticipated money supply variables should not be statistically significant at any meaningful level of significance. Results obtained from testing eq. (2) for the $/C$ and $/DM rates are presented in tables 3 and 4. Apparently the results reported in tables 3 and 4 support the hypothesis that all of the adjustment process is quick and that the informational efficiency of the market cannot be rejected since both b1 and bz are not significantly different from zero. Thus our results indicate that the foreign exchange market is efficient with respect to the information contained in money supply announcements. 3.3. The response of the forward market to money supply announcements

To determine the response of the forward market to weekly money supply 4The components of the W. German money supply have not been tested because Germany does not announce its money supply aggregates on a weekly basis. Bundesbank announces money supply figures monthly.

obsr 50

obs: 47

obs: 49

obs: 50

obs: 45

obs: 43

b,

b,+

b2

b,dS+

bagAN+

- 3.1445E-02 (-0.877) 4.6920B02 (0.786) 6.5407B02 (0.980) -4.5554B02 (-0.506) 7.5133E-02 (0.159) - 5.8229E-02 (-0.592)

b,m,us+

2.2387E-04 2.8429B02 (1.232) (0.913) - S.O05OE-04’ 5.5127EG02 (- 1.881) (0.958) -2.2393E-04 l.O567E-01 (-0.520) (1.511) -5.1505E-04 -4.4938E-02 (- 1.180) (-0.562) -4.7167E-04 1.387OE-03 (-0.731) (0.144) - 5.020~04 2.4522E-03 (-1.003) (0.160)

Constant

Estimated coefficients

S,-SF=

- 1.0661EA4 (-0.011) - 1.8243E-02 (- 1.252) - 2.9288E-02 (- 1.601) 3.2579B02 (1.069) 1.4932E02 (0.383) -2.1980B02 ( - 0.476)

b,

b,dAN+

uc.

(-0.081) - 1.8581B03 (-0.186) - 1.7166E-02 (-1.044) 6.4992E-03 (-0.337) - 2.0193E-03 (0.094) -4.6305E-02 (-1.007)

- 5.9503Bo4

b,

0.0503

0.0237

0.0439

0.1165

0.0610

0.0987

K2

statistics

SUlllm~

1.8714

1.8930

2.0101

2.1141

1.8970

2.0001

D-W

Table 3 evidence on the relation between Friday to Monday changes in the spot (S/C%) exchange rate and U.S. and Canadian anticipated and unanticipated weekly money supplies (t-statistics in parentheses):

“Significant at the 10% level.

1974 no. of 1975 no. of 1976 no. of 1977 no. of 1978 no. of 1979 no. of

Estimated period

Empirical

316

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and M. Melhem,

Spot and forward

rates

reaction to new information

Table 4 Empirical evidence. on the relation between Friday to Monday changes in the spot (%/JIM) exchange rate and the U.S. anticipated and unanticipated weekly money supply (t-statistics in parentheses):

Summary

statistics

Estimated coefiicients Estimated period 1974 no. of 1975 no. of 1976 no. of 1977 no. of 1978 no. of 1979 no. of

obs: 43 obs: 45 obs: 50 obs: 49 obs: 47 obs: 39

Constant l.O239E-03 (1.339) -2.3487E-03 (- 1.284) 1.2767E-02 (0.923) 3.6255B03’ (2.329) 3.6245E-03 (1.191) 2.894OE-01’ (1.840)

h - 3.9390B02 (- 1.096) 1.4111E-01 (0.445) 2.7330E-01 (1.353) 3.8965E-02 (0.137) -4.4053B02 (-0.655) 3.9402E-02 (0.242)

b, -4.9234E-02 ( - 1.406) 7.9990E-02 (0.220) -8.3596E-02 ( - 0.424) -3.8401E-03 (-0.012) -4.2562E-02 (-0.654) - 3.7250E-02 (-0.175)

R2

D-w

0.0051

2.1401

0.0773

2.0612

0.0828

1.8962

0.0010

2.0714

0.0205

2.2212

0.0310

2.0040

‘Significant at the 10% level.

announcements eq. (3) is estimated for the one-month, three-month and sixmonth $/C$ and $/DM forward exchange rates. In all regressions the impact of the unanticipated U.S. money supply movements on the forward rate changes turned out to be larger than that of the anticipated movements.5 Tables 5 and 6 present only the unanticipated effect of the U.S. money supply on the Thursday to Friday change in the spot and forward rates for the $/C$ and the $/DM rates, respectively. Apparently the results indicate, with the exception of 1978, that there is a negative relationship between the unanticipated money supply movements and forward exchange rates. This relationship, however, is statistically significant only in the spot foreign exchange market (see 1976, 1977 and 1974-1977). On the other hand, we observe that such a relationship is not only statistically insignificant, with the exception of 1976 for one-month forward contracts, but declining as the forward contract period increases. This suggests that spot exchange rates (foreign exchange prices for one or two trading days delivery time) are more volatile compared to forward exchange rates (foreign exchange prices for one-, three- and six-month delivery time). In other words, the jump in the spot price, immediately after the unanticipated money supply announcements, exceeds the jump in the futures price. This finding provides support ‘These results are not reported here, but they are available upon request from the authors.

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to new information

317

for the law of increasing price volatility, derived by Samuelson (1965) using a model of futures price formation, in the context of the foreign exchange market. Finally, the exchange rate differential response between spot and forward rates immediately after unanticipated money supply changes yields evidence for overshooting of the kind Levich (1981) defmes ‘as a short-run response that exceeds the long-run response’. This result is also consistent with Dornbusch’s (1976c) model of short-run exchange rate behavior. The difference is that according to Dornbusch model, overshooting obtains when the money supply disturbance occurs in the initial period (t =0), while in this study overshooting results when agents anticipate a future monetary change (t= 7’). Thus our results demonstrate that if agents today anticipate a future monetary change, Fed is expected to counteract an unexpected money supply jump, their action will cause exchange rate overshooting. Finally, this differential response between spot and forward rates to money supply announcements provides further support for the policy anticipation effect. This means that announcements of monetary innovations primarily affect the ex ante real interest rate and have very little impact on inflationary Table 5 Comparison of the effect of the unanticipated U.S. money supply on the change in the $/C% exchange rate from Thursday to Friday. Estimated period 1974 1975 1976 1977 1974-1977 1978 1979 1977-1979 ‘t-statistics 6M represent respectively. ‘Significant CSignificant

spot -4.7553E-03 (-0.083) -4.1384E-02 (-0.720) -l.O701E-Olb (0.923) - 1.5572E-Olb (- 1.897) - 7.1096E-02’ (-2.156) 3.4490E-02 (0.835) -2.0465E-Olb ( - 1.946) -4.268OE-02’ (-2.027)

1M - 2.2218E-02 (-0.399) - 1.6789E-01 (-1.409) - 1.0797E-Olb (- 1.736) - 9.4046E-02 (-0.965) -9.0856E-02 (0.737) 3.4625E-02 (0.810) -4.5220E-01 (-0.970) -7.6350E-Olb (- 1.822)

3M - 1.3675B02 (0.257) - 1.7083E-01 (-1.418) - 8.7642E-02 (-1.438) -8.766OE-03 (-0.902) -8.5611E-02 (- 1.038) 3.5207B02 (0.803) -4.3789E-01 (-0.958) -7.0129E-02 (-1.014)

6M 3.8824E-03 (0.068) - 1.8299B01 (-1.527) - 6.9689E-02 (-1.021) -8.1361B02 (-0.828) - 7.2844E-02 (-1.004) 3.9649E-02 (0.954) -4.70443-02 (-0.825) -6.925OE-02 (-0.990)

in parentheses. Spot=spot $./C$($/DM) exchange rates. lM, 3M and l-month, 3-month and 6-month forward $/C$($/DM) exchange rates at the 10% level. at the 5% level.

J. Doukas

318

and M. Melhem,

Spot and forward Table

Comparison

rates reaction 6

of the et&t of the unanticipated the $/DM exchange rate from

Estimated period 1974 1975

spot

1M

- 3.494E-02 (-0.214) -9.719E-02 (-0.666)

-3.878E-02 (-0.242)

- 1.628E-OIC (0.923) - 1.557E-Olb (- 1.803)

1976 1977 1974-1977

- 7.707 E-02 (- 1.286)

U.S. money supply Thursday to Friday.

3M

- 1.472E-01 (-1.681)

- 1.367E-01 (-0.715) - 1.440E-01 (-0.688)

((-

- 7.509B02 ( - 1.267)

(-

-8.121E-02 1.366)

(-

- l.OllE-01 (-0.652) (-

- 1.464E-01 1.828)

1.946E-03 (0.025)

1979

- 1.82OOE-01” (-2.004)

(-

-3.5820E-02b (- 1.840)

- 3.525OE-02 ( - 1.792)

- 1.6550E-01 1.587)

b

in

6M - 1.388E-01 (-0.818)

7.274E-03 (0.096)

“See table

on the change

- 7.443E-02 (-0.452) - l.l90E-01 (-0.0835)

1978

1977-1979

to new information

- l.O366E-01 (-0.728)

1.219E-02 (0.160)

l.O97E-01 1.343) 1.424E-01 1.632)

-8.813E-02 1.458) 5.0349E-02 (0.601)

- 1.6004E-01 (-1.291)

- 1.5287E-01 ( - 1.030)

-3.3115E-02 (-1.271)

(-

- 3.4067E-02 1.305)

5.

expectations. If money supply innovations have an impact on inflationary expectations, then the entire term structure of exchange rates would shift. 4. Empirical evidence using survey data Each week since September 21, 1977 Money Market Services of San Francisco has conducted a survey of government securities dealers and economists for their expectation of the money supply, Ml, due to be released on the following Thursday. The median forecast is made public by Money Market Services after the money supply announcement. The innovation in the weekly money supply is measured by subtracting the expected change in the money supply from the reported change. The survey forecast was examined to see if it satisfied minimal standards of efficiency and unbiasedness. The null hypotheses, that the survey expectations data are efficient and unbiased, were not rejected. This is consistent with results previously obtained by Grossman (1981), Urich and Wachtel (1981,1984), Cornell (1983a) and Engel and Frenkel (1984). Unfortunately, the survey covers only the U.S. money supply, so no data are available for the Canadian money supply. In this section, we test for the effect of the announcements on the spot and forward market. The equations used for these tests are comparable with eqs.

J. Doukas

and M. Meihem,

Spot and forward

rates reaction

to new information

319

(l)-(3) except that the forecast errors, defined as the actual change minus the median forecast, is substituted for the autoregressive residuals. Tables 7 and 8 show estimates of these equations for monetary announcements which are comparable with the results reported in tables 1-4 and 5-6, respectively. These regressions test for the presence of an immediate announcement effect, since the dependent variable is the change in exchange rates before and after the Federal Reserves’ announcement. These results are quite satisfactory, both from the point of view of the perspective of the signs and level of significance of the coefficients. Broadly speaking, the empirical evidence reported in tables 7 and 8 shows great similarity to the results obtained using the autoregressive residuals as independent variable in the estimation of eqs. (1)-(3).6 The results are consistent with the view that foreign exchange market participants use information other than past money supply changes in forming the expectations since the survey data produce slightly better results. That is, regression coefficients are higher, on average, when survey data are used. 5. Conclusions This paper has investigated the relationship between exchange rate (spot and forward) changes and new information. In particular we have tried to utilize the asset-market approach to the analysis of the exchange rate behavior and market anticipations of future money growth in providing a framework within which to analyze (1) the response of the spot exchange rate to anticipated and unanticipated money growth, (2) the speed of adjustment of the foreign exchange market to weekly money supply announcements, and (3) the response of forward exchange rates to these announcements. Investigating the response and in particular the speed of adjustment of the spot foreign exchange market to weekly money supply announcements is essentially a test of market efficiency. Finally, added insight into the behavior of exchange rate can be gained by concentrating on the response of the forward exchange market to money supply innovations too. The results reported here are consistent with the findings of prior research on interest rates over the same period [see Grossman (1981), Urich and Wachtel (1981)] and support in general the policy anticipation effect. The policy anticipation view predicts a negative relationship between unanticipated money supply announcements and the exchange rate (dollar appreciation) as the market anticipates future monetary tightening by the Fed.’ %milarly, Cornell (1983a) having found no difference between the autoregressive residuals and the survey forecast errors variable in a study on the reaction of the treasury and bond markets to Federal Reserve’s weekly money supply announcements arrived at the same conclusion as that of Urich and Wachtel (1981) concerning the appropriateness of ARIMA model estimates for proxying expectations. ‘See Urich and Wachtel(l981) and Cornell (1982) for a detailed description of this effect.

period

at the loo/, level. at the 5% level.

D-W

*Significant bSignifkant

1.8403

I2

b,

h

1.8842E-04 (0.361) 5.011 lE-03 (0.403) 0.0418

Constant

-3.627OJZ-04 (-0.512)

no. obs: 39

no. obs: 47

2.0220

0.1226

2.4395B-03 (0.183) - 3.0205E-02 (-0.574)

-5.1007E-05 (-0.121)

forecast

Table

1.8417

2.0014

0.0552

3.8294E-02 (0.269)

-4.1568E-05 1.092)

2.6732E-03 (0.112)

(-

no. obs:

101

as independent

2.0126

- 3.9064E-03 ( - 0.463)

- 3.5837E-02 ( - 0.420)

2.7319E-03 (0.883)

no. obs: 47

1.7805

2.4831EO2 mw 0.0310

3.035933-02 (0.219)

-4.2015JZ-M (-0.167)

1978 no. obs: 47

W. Germany Estimated period

errors

Sb(-Sp=bo+bl~~+bz’L1.US+U1

2.0210

0.0802

- 3.4609E-01’ ( - 1.722)

- 5.392OE-05 (-0.102) - 3.481OE-02 (-0.178)

1.9413E-02 (0.147)

0.0449

7

1977-79 no. obs: 82

SF-Sm=bo+b,~s+b,+u,

survey

2.8951E-02 (0.265)

-7.2579B-04 (-0.809)

no. obs: 62

1.8620 (B)

2.0102

D-W

0.0449

1.9803

0.0512

AT

0.0358

-3.691OE-03 (-0.903)

2.939OE-02 (1.325)

b,

h

Constant - 1.533OE-02 c-0.446) -3.0850E01b (- 1.992)

1977-78 no. obs: 62

(A)

rates using

-2.158OE!-O2 (-0.336)

1979 no. obsz 40

exchange

-4.0382E-05 (-0.201)

1978 no. obs: 47

Canada Estimated

on spot

-4.1281JMS (-0.152)

of

effects

-8.4532E-04 (-0.178) -3.034033133 (-0.531)

Estimate coefficient and summary statistics

Announcement

no. obs: 37

1.9311

0.0702

-4.0031B-01” 1.672)

1.8602

- 2.8525E-02 (-0.542)

3.1267E-03 (0.225)

- 1.8352E-03 (-0.944)

(-

-2.4892E-03 (-0.166)

-3.0612E-04 (-0.501)

1977-78 no. obs: 64

2.0150

0.0620

-8.3921B-03 (-0.647)

-4.0052B03 (-0.830)

3.8256E-02 (0.859)

no. obs: 61

0.0625 2.0001

-2.6683E-03 (-0.592) -2.9063E-02 (- 1.2093)

1977-79 no. obs: 92

2.1004

0.0839

-4.9357E-03 (-0.345)

-3.2914E-02 (-0.712)

3.4971E-03 (0.672)

no. obs: 98

1.8503

0.0538

-4.0712E-04 (-0.281) -2.8147E-01” (-1.618)

-8.225OE-04 (-0.170)

in parentheses):

-5.1607JZ-03 (-0.442)

(r-statistics

1979 no. obs: 38

variables

2.9390E-02 (1.325) 3.3750B02 (0.847) 2.4614E02 (0.824) 3.0127E02 (0.812) 3.2106E02 (0.820)

1978

-3.6910B03 ( - 0.903) -6.2250E03 (-0.582) - 5.0458E3-02 ( - 0.575) -3.132833-02 (-0.402) -3.3482B03 ( - 0.430)

1979

Canada: Estimated period

-3.0850EOlb (- 1.992) -4.6170E-01’ (- 1.584) -4.2493B02 (-0.725) -4.0537E.-03 (-0.649) -4.3871E-03 (-0.652)

1977-78 -3.4609BOl’ (- 1.722) -2.8990E-01’ (- 1.748) -3.1553B02 ( - 0.420) - 3.226OE-02 ( - 0.428) -4.1465E-02 (-0.582)

1977-79 -2.4831E-02 u.004) 2.002OE-02 (0.104) 1.9810B03 (0.125) lA263E-02 (0.204) 4.2517E-02 (0.773)

1978 -4.0031EOl’ (- 1.672) - 1.824OB02 (-0.350) 2.5628E-03 (-0.380) - 5.8409E-03 (-0.372) -3.2915E-02 (-0.429)

1979

W. Germany: Estimated period

-2.9063E-02 (- 1.2093) -2.543OE-02 (-0.374) -4.0019E-03 (-0.440) -4.5210E-03 ( - 0.660) -4.2802E-03 (-0.601)

1977-78

-2.8147E-01” (- 1.618) -2.0091E-02 (-0.356) -3.9024E-02 ( - 0.725) -3.223OE-02 (-0.427) - 3.4822E-03 ( - 0.284)

1977-79

‘Significant at the 10% level. Spot-spot %/C$ (%/DM) exchange rates. lM, 3M and 6M represent l-month, 3-month and 6-month forward $/C$ ($/JDM) exchange rates, respectively. bSigniticant at the 5% level.

6M

3M

2M

1M

spot

Foreign exchange contracts

Announcement

Table 8 effects on forward exchange rate changes from Thursday to Friday using survey forecast errors as independent variables (tstatistics in parentheses).

322

J. Doukas

and M.

Melhem,

Spot and forward

rates reaction

to new information

A negative and statistically significant relationship is found between weekly U.S. announced money supply innovations and current exchange rates ($/CS, $/DM), with the exception of 1978. Uncertainty about the Fed’s future policy and foreign exchange intervention might be responsible for the positive relationship between unanticipated money supply changes and the dollar price of the Canadian dollar and the Deutsche mark during 1978. Our findings for the pre-October 1979 are also similar to those reported by Cornel (1982, 1983a,b) and Engel and Frankel (1984) for the post-October 1979 period, though the coefficient of the unanticipated money supply variable and its t-statistic in both studies are slightly higher. Thus the results reported in tables 1 and 2 demonstrate that unanticipated money supply changes had a significant positive impact on the ex ante real rate of interest which, in turn, induced an incipient inflow of capital and a dollar appreciation. In addition, the evidence on the speed of adjustment clearly indicates that the foreign exchange market is efficient with repect to the information contained in the money supply announcements. The results presented in tables 3-4 and 7 show that the effect of the unanticipated changes in the money supply on the changes in the Friday to Monday exchange rates are not significantly different from zero. On the other hand, we found that the impact of the unanticipated money variable on the Thursday to Friday exchange rates is statistically significant. This finding supports the assetmarket theory of the exchange rate determination in the sense that exchange rates immediately adjust to reflect ‘new information’ received by the market. Finally, the results on the response of the forward market to money supply announcements reveal that the relationship between forward exchange rate changes and the unanticipated money supply variable is statistically insignificant, with the exception of 1976 for one-month forward contracts, and declining as the forward contract period increases. This result is consistent with both Samuelson’s (1965) low of increasing price volatility and Levi&s (1981) definition II of exchange rate overshooting. Furthermore, the differential response between spot and forward exchange rates ‘to unanticipated money supply announcements implies that money supply announcements do not produce a permanent change in people’s inflationary expectations. If money supply innovations induce agents to revise their inflationary expectations, then the entire term structure of exchange rates should shift. In sum, the results obtained provide support to the asset-view of exchange rate determination that postulates that exchange rate movements basically respond to new information. With respect to the Samuelson’s (1965) low of increasing price volatility and Levich’s (1981) notion of exchange rates overshooting, the results obtained were conclusive.

.I. Doukas

and M. Melhem,

Spot andjorward

rates reaction to new information

323

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324

J. Doukas

and M. Melhem,

Spot and forward

rates

reaction

to new information

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