Infrequent Large Nominal Devaluations and their Impacton the Futures Prices for Foreign Exchange in Brazil
IMF Working Papers, May 1, 1996
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- Infrequent Large Nominal Devaluations and their Impacton the Futures Prices for Foreign Exchange in Brazil
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Bibliographic details
- Published: May 1, 1996
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451846799.001
Summary and main findings
- Examines behavior of futures prices for foreign exchange in Brazil during a period of high inflation and successive stabilization attempts (1989-92).
- Tests for futures prices unbiasedness and predictability by applying the Generalized Method of Moments.
- Finds evidence of excess returns in futures contracts.
- Interprets excess returns as a rational market response to frequent and unpredictable changes in exchange rate policy during the sample period.
- Presents two alternative explanations for the observed futures bias:
- (i) An informational problem where the exchange rate policy is assumed to be unknown to market participants.
- (ii) A “peso” problem of rational (under) overprediction where the futures bias is the market response to the known policy of infrequent large nominal devaluations.
- The “peso” explanation is supported by conditioning the probability distribution of the excess return of futures contracts on the event of a major devaluation.
Methodology
- Empirical approach: Generalized Method of Moments used to test unbiasedness and predictability of futures prices.
- Sample period explicitly identified: 1989-92.
Interpretation and scenarios
- Informational-uncertainty scenario:
- Markets treat exchange rate policy as unknown, generating excess returns as compensation for informational risk.
- Peso-problem scenario:
- Markets rationally under- or overpredict typical outcomes because of a known policy of infrequent large nominal devaluations; futures bias reflects market pricing of the low-probability, high-impact devaluation events.
- Evidence for the peso scenario obtained by conditioning the probability distribution of futures excess returns on occurrence of a major devaluation.
Subjects and keywords (as provided)
- Subjects: Econometric analysis, Estimation techniques, Exchange rate devaluation, Financial institutions, Financial markets, Foreign exchange, Futures, Futures markets, National accounts, Return on investment.
- Keywords: devaluation agent, devaluation rate, Estimation techniques, exchange rate, Exchange rate devaluation, expected devaluation, forecast error, Futures, Futures markets, inequality coefficient, last trading day, least squares, periods Ft, Return on investment, risk premium, risk premium Rt, risk premium test, sample period, underpredicting FT, WP.