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New paper sees no link between forward exchange rate and future spot rate

The forward exchange rate cannot be an unbiased indicator of the future spot rate, according to a research paper written by Himanshu Joshi and Mridul Saggar of the Reserve Bank of India.

''If markets are efficient, then forward rates must be unbiased predictors of the future spot rates and no excess returns should exist in the markets,'' the paper says.

The authors say the Indian forex market does not pass the test of efficiency. The paper suggests that since the events in the spot and forward markets are somewhat insulated from each other, intervention in one market needs to be supplemented by the same in the other.

''RBI intervention has generally been passive during periods when the exchange rate has been relatively stable. However, on occasions, the RBI has been compelled to step up intervention by selling dollars forward to cool the premia or by conducting buy/sell operations to dampen intra-day or day-to-day volatility,'' the paper says.

The paper further says the RBI also undertakes swaps when the forward premia go out of alignment with short-term interest rates. One reason for doing this is to smoothen the maturity profile of forward liabilities and ensure that they remain prudent in size.

''Ordinarily, the swaps would not influence the forward rate, but it is useful not just for altering monetary conditions, but also for exchange rate management,'' the authors say. There is a presence of higher volatility of the permanent component of the spot exchange rate against its temporary component thus implying a dominant role played by exchange rate variations.

The predominant role of the permanent component established in the paper supports the RBI's strategy of concentrating on the fundamentals of the economy and modulating the monetary conditions. ''The results underscore the importance of the policy of intervention in different market segments as needed and its emphasis on continuous monitoring of the critical fundamentals of the economy to ensure their reflection on the exchange rate,'' the paper concludes.

UNI