How the forward exchange rate can be set by speculators

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1. Why is it true that the hypothesis that the forward exchange rate is an unbiased predictor of the future spot exchange rate is equivalent to the hypothesis that the forward premium (or discount) on a foreign currency is an unbiased predictor of the rate of its appreciation (or depreciation)?

2. It is often claimed that the forward exchange rate is set by arbitrage to satisfy (covered) interest rate parity. Explain how interest rate parity can be satisfied and how the forward exchange rate can be set by speculators in reference to the expected future spot exchange rate.

3. It is sometimes asserted that investors who hedge their foreign currency bond or stock returns re- move the foreign exchange risk associated with the investment, reduce the volatility of their domestic currency returns, and thus get a "free lunch" because the mean return in domestic currency remains the same as the mean return in the foreign currency. Is this true or false? Why?

Reference no: EM13897856

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