Essays on the forward discount bias and exchange rate volatility

Essay One analyzes the forward discount bias in the foreign exchange market as influenced by monetary policy rules. A government response function to external shocks is combined with the monetary model for foreign exchange rate determination. The forward discount bias is more probable when the government is concerned about interest rate smoothing than when monetary policy focuses on price-level or foreign exchange rate stabilization. In Essay Two the profitability of a trading rule in the foreign exchange market based on the forward discount bias is examined. The out-of-sample results vary among currency markets and maturities of the forward contracts. The profitability in long-term maturity forward market (6 or 12 months) is higher than in short-term maturity contracts (1 or 3 months). The profitability does not change significantly with the consideration of the asymmetry found in the forward discount bias or the deviation from long-run equilibrium exchange rates. Nevertheless, most risk adjusted mean returns are insignificantly different from zero. Two propositions in Carlson and Osler\u27s rational speculator model are examined in Essay Three: first, if interest-rate shocks occur, the conditional variance of the exchange rate is monotonically increasing in the amount of speculation. Second, the conditional variance of the exchange rate is monotonically decreasing in the amount of speculation if current-account shocks occur. The empirical results suggest that the first hypothesis is supported better than the second one. The results are more clear when implied volatility data from currency option market are used. Especially, the GARCH results of Korean exchange market support the two hypotheses well, in which exact transaction volume is used as the proxy of speculation amount