After eight years under the Bretton Woods system, Canada returned to a regime of flexible exchange rates in May 1970. Over the remainder of the decade many other countries joined Canada in adopting flexible rates, and this movement has opened up a fertile new area for study by economists. This dissertation examines the Canadian foreign exchange market from several different points of view. It begins by comparing a number of theoretical models currently found in the literature, showing the common theoretical core from which the models are derived, as well as the differences among them. The models are then estimated using Canadian and U.S. quarterly data over the period 1971-78, and compared to one another on the basis of fit. The dissertation then turns to the question of prediction. Using the models discussed above, and time-series forecasts of the explanatory variables, monthly forecasts of three-month-ahead exchange rates are constructed for the period 1974-78. Care is taken to ensure that all forecasts are based only on information available to the market at the time the forecast was to have been made. The forecasts of the three-month-ahead exchange rate are compared to one another and also to the three-month forward rate, which is taken to be the market's forecast of the future value of the exchange rate. It is shown that the models' forecasts and the forward rate each contain separate information valuable in forecasting the future spot rate. The models and the forward rate are combined to produce a set of 'optimal' forecasts. The final chapter of the dissertation focuses on speculation and market efficiency. It is shown that the forecasts can be combined with a crude betting strategy to produce speculative profits over the sixty periods from 1974-78. No conventional measure of risk can be constructed, but it is shown that the probability of mean returns being negative after sixty bets is less than one percent. When transaction costs are taken into account, speculative returns are reduced, but the probability of average returns being negative after sixty bets remains less than one percent. Thus all of the estimated models appear to contain information that was not efficiently used by participants in the foreign exchange market between 1974 and 1978. Subsequent research will be required to tell whether this represents a learning period for market participants, or whether exchange market participants will continue to undervalue available information. / Arts, Faculty of / Vancouver School of Economics / Graduate

The United States operates a dual payments system which gives rise to the distinction between Clearing House Funds and Federal Funds. Due to the fact that, unlike the United States, Canada operates a single payments system, a potential arbitrage opportunity arises in transacting between the Canadian and U.S. money markets on certain days of the week. There are essentially two situations in which U.S. investors can have an interest: the Friday-Monday transaction and the Thursday-Friday transaction. Since both the foreign exchange market and the money market are almost certainly efficient, any potential arbitrage opportunity should be eliminated by adjustments in both markets. This paper looks at the impact of the transactions that would tend to eliminate any arbitrage opportunity, upon interest rates and exchange rates. The institutional details for arranging such transactions are also examined. Only the implications in the foreign exchange market were empirically tested using daily spot rates and forward rates from 1973 to 1976. Since daily interest rates in this period were not available, only one example of daily variation of interest rate within a week was illustrated. It was found that transactions in both the spot market and the forward market have to be arranged one business day in advance. Therefore, the spot/forward rate is also quoted one business day in advance (for example, spot/forward rate that prevails on Thursday is quoted for Friday's transaction). Hence the rate implication from the movements of funds should be shifted one business day backward. The results show that the day-to-day movements in the spot and forward markets are as we would expect. Within the foreign exchange market, the forward rates adjust to a greater extent than the spot rate in eliminating the advantage that arises from the movements of funds. This also indicates that most investors prefer to cover their investments by arranging forward contracts. The arbitrage opportunity that arises involving movements of funds between Canada and the United States is also applicable between the United States and any European country that operates a single payments system. The theory behind it is identical to that described in this paper. Finally, it was found that even if banks in Canada and the United States use the Society for Worldwide Interbank Financial Telecommunications (S.W.I.F.T.) for a number of transactions in the near future, mechanisation of the International cheque clearing systems is not one of the functions for which S.W.I.F.T. will be used. Therefore,the "Big Fridays" operations are expected to continue. / Business, Sauder School of / Graduate