Applying Economic Restrictions to Foreign Exchange Rate Dynamics: Spot Rates, Futures, and Options

WP 96-2

Posted: 26 Jun 1998

See all articles by Michael U. Dothan

Michael U. Dothan

Willamette University - Atkinson Graduate School of Management

Buddhavarapu Sailesh Ramamurtie

Independent

Scott Ulman

Financial Solutions Inc.

Date Written: April 1996

Abstract

Extant models of exchange rate behavior have typically relied on statistical rather than economic considerations. The approach has been to employ a variant of the generalized central limit theorem to develop tests for the models proposed. We propose a minimal set of simple economic restrictions -- symmetry, invariance, and non-negativity -- that must be satisfied by an exchange rate process. By symmetry, we mean that both the direct and indirect exchange rate processes must belong to the same class of distributions. By invariance, we mean that the distribution for an exchange rate must be invariant to changes in the currency unit. By non-negativity, we mean that the exchange rate process must preclude negative values. We identify various alternative specifications for exchange rate processes and show that some of them do not possess some or all of the above properties. Finally, we propose a new exchange rate process -- the mean-reverting logarithmic process (MRL) -- and develop valuation equations for several exchange rate instruments, from forward and futures contracts to straight options on the spot rates to options on the futures contracts.

JEL Classification: F31, G13, G15

Suggested Citation

Dothan, Michael U. and Ramamurtie, Buddhavarapu Sailesh and Ulman, Scott, Applying Economic Restrictions to Foreign Exchange Rate Dynamics: Spot Rates, Futures, and Options (April 1996 ). WP 96-2. Available at SSRN: https://ssrn.com/abstract=7486

Michael U. Dothan

Willamette University - Atkinson Graduate School of Management ( email )

900 State Street
Salem, OR 97301
United States
(503) 370-6440 (Phone)

Scott Ulman

Financial Solutions Inc. ( email )

Minneapolis, MN
United States

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