A simultaneous model of the US dollar/Deutschmark spot and futures markets

Introduction Traditional economic models of exchange rate determination have performed poorly in recent decades in that they are unable to explain a significant proportion of exchange rate variation and are unable to outperform a naive random walk model in post-sample forecasting. Critics such as Isard (1987), Meese (1990) and others have discussed these issues and have drawn attention to perceived deficiencies in traditional models, including undue reliance on single equation methods, inadequate modelling of expectations and insufficient attention to capital flows (see Isard, 1987, pp. 3, 15, 16; Meese, 1990, p. 117). This chapter addresses these questions. A simultaneous model of the US dollar/Deutschmark exchange rate is developed using information from both spot and futures markets. The model contains separate functional relationships for short and long hedgers, for short and long speculators in futures, and for unhedged spot market commitments. This chapter has its foundations in the theoretical model of Peston and Yamey (1960) and in the empirical commodity market models of Giles et al. (1985) and Goss et al. (1992), and extends the work of Goss and Avsar (1996) on foreign exchange from minor to more active markets.