FINM8007 Chap.6 FX Forecasting, Speculation and Arbitrage
FX Forecasting, Speculation and Arbitrage
Forecasting a price that reacts to forecasts
Multinationals forecast exchange rates for sourcing, financing and pricing decisions.
This chapter compares the efficient market approach and its random walk, fundamental econometric models and technical analysis, from Dow theory and chart patterns to filter rules and moving-average crosses, and matches each to a horizon.
Taking a view, or taking no risk
It then shows how institutions speculate with borrowed money in the money market or with forwards, and how locational, triangular and interest arbitrage work with real bid and ask quotes, including the price pressures that close each opportunity.
Where marks are won and lost
The Week 7 practice solutions lay out every arbitrage and speculation answer the same way: identify the mispricing with the correct side of each quote, list each trade in sequence with its amount, compute the profit, then explain the market pressure each trade creates.
Speculation answers must say the profit is expected, not certain, and must use borrowed funds when the question says so.
Forecasting questions in the tutorials are written answers that name the approach, its assumption about information and the horizon it suits.
How it connects
Forecasts feed the exposure measures of Chapter 7, since value at risk needs an expected change and a volatility, and the hedging choices of Chapter 8, where the unhedged alternative is valued with a forecast.
The arbitrage relationships explain why quotes, cross rates and forward rates in every other chapter can be treated as consistent with each other most of the time.
What this chapter covers
- 01
Why firms forecast
- 02
Three forms of market efficiency
- 03
Fundamental models
- 04
Technical analysis and moving averages
- 05
Forecasting horizons
- 06
Money-market speculation
- 07
Locational arbitrage
- 08
Triangular arbitrage with spreads
Worked example · free
Spot the golden cross in a short price series
- 14-day average on day 16: (0.660 + 0.660 + 0.668 + 0.672) ÷ 4 = 0.665.
- 110-day average on day 16: drop day 6 and add day 16, (6.634 − 0.674 + 0.672) ÷ 10 = 0.6632.
- 1On day 15 the short average was below the long one (0.659 against 0.6634); on day 16 it is above (0.665 against 0.6632).
Key terms
- Random Walk
- A model in which the best forecast of tomorrow’s rate is today’s rate.
- Filter Rule
- A technical rule that buys after a set rise from a trough and sells after a set fall from a peak.
- Golden Cross
- A short moving average crossing above a long one, read as a buy signal.
- Locational Arbitrage
- Buying a currency at one bank and selling it at another whose bid exceeds the first bank’s ask.
- Triangular Arbitrage
- A loop through three currencies that profits when a quoted cross rate departs from the implied one.
- Covered Interest Arbitrage Threat
- The pressure that keeps forward quotes consistent with interest rate differences.
FX Forecasting, Speculation and Arbitrage FAQ
Can fundamental models beat a random walk?
On the evidence the lecture summarises, econometric models of fundamentals forecast no better than a random walk or the forward rate. Any relationship that holds reliably is soon discovered by others, and prices then adjust to remove it.
What is the signal for locational arbitrage?
One bank’s bid for a currency must be higher than another bank’s ask. Different mid rates alone are not enough, because the spreads may absorb the gap once you buy at an ask and sell at a bid.
Why are arbitrage profits rare today?
Banks are connected continuously to the same quotes and use technology that detects and trades misalignments almost instantly, so gaps close before most traders can act. Gains also shrink once bid-ask spreads are paid on every leg.
How does speculation with a forward differ from money-market speculation?
A forward expresses the view in a single contract at today’s forward rate, while money-market speculation borrows one currency, converts it and lends the other. Both profit only if the spot rate moves as expected, and the forward route needs no borrowing capacity.
Exam move
Write one speculation and one arbitrage trade for each currency pair you study, and label every leg as locked in or open; any open leg makes it speculation. Finally, write two sentences on why a profitable technical rule does not by itself prove the market is inefficient.
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