A Reinterpretation of the Modern Theory of Forward Exchange Rates

THE MODERN THEORY of forward exchange rate determination (MT) has been widely, although not unanimously, accepted as an improvement over the traditional interest rate panty theory (IRPI ). The latter theory contends that in equilibruim the forward rate F will equal (except for transactions costs) the interest panty forward rate F*. 1 Covered interest arbitrage (CIA) is a pnmary (but, as shall be seen, not the only) force insunng this equilibnum condition for the forward market. For example, if F exceeds F*, then covenng arbitrageurs borrow (or forego lending) in the domestic country, purchase the foreign currency on the spot market, lend abroad at the foreign interest rate, and simultaneously sell the foreign currency (including interest) on the forward market. These transactions cause F to decline and/or F* to increase until equilibnum is restored. Motivated in part by early empincal studies of the IRPI which found evidence of apparent deviations of F from F* and by the intuitively appealing argument that expectations (or speculation) can also influence F, the MT suggests that the equilibrium forward rate is better explained as a weighted average of F* and the expected