Less of a Puzzle: A New Look at the Forward Forex Market

Abstract

The two-country monetary model is extended to include a consumption externality with habit persistence. The model is simulated using the artificial economy methodology. The 'puzzles' in the forward market are re-examined. The model is able to account for: (a) the low volatility of the forward discount (b) the higher volatility of expected forward speculative profit (c) the even higher volatility of the spot return (d) the persistence in the forward discount (e) the martingale behavior of spot exchange rates (f) the negative covariance between the expected spot return and expected forward speculative profit. It is unable to account for the forward market bias because the volatility of the expected spot return is too large relative to the volatility of the expected forward speculative profit.

Keywords: artificial economy, forward foreign exchange, habit persistence

JEL Classification: F31, F41, G12