Enhancing the Estimation of the Realized Future Spot Exchange Rate

Investors use the daily forward points that are quoted in the Forex market as an indicator to help calculate the expected realized future exchange rates. These forward exchange rates (expected realized future exchange rate) are then used in foreign exchange transactions and decision-making processes. However, research shows that there is a great difference between the forward exchange rate, which is a presently being estimated, and the realized future spot exchange rate. This statement was also emphasized by Diamandis et al. (2008:358) and Albuquerque (2008:461) that stated that the forward exchange rate is a biased predictor of the realized future spot exchange rate. This paper reports on a model that is able to enhance the estimation of the realized future spot exchange rate, between the South African Rand (ZAR) and the U.S.-Dollar. This paper follows two approaches. The first approach consists of a vector error correction model that determines the speed of adjustment of the volatility of dual-listed stocks on the Johannesburg Stock Exchange (JSE) and the New York Stock Exchange (NYSE). The results from this approach are used to generate the expected values required. The second approach follows the methodology of Chiang and Yang (2007), where the price difference of dual-listed stocks, the interest rate differential, and the expected inflation differential between two countries (South Africa and the U.S.A.) are used to forecast the future realized spot exchange rate.