Currency Price Risk Hedging and Speculation in a Random Walk Market

Abstract

If the spot price of a currency follows a random walk with no drift, it will be a better predictor of the future spot price than the futures price. Using data over the 1984–1995 time period, the authors conclude that both foreign currency hedgers and speculators should follow this principle when they make trading decisions. In general, currency futures should be sold when they are above the spot price, and futures should be bought when they are below the spot price. Performance is greatly improved if the trader employs stop loss orders, and also reverses the futures position if and when the initial signal reverses.