The Behavior of Foreign Exchange Rates

Author(s): Jorge R. Calderon-Rossell and Moshe Ben-Horim

Source: Journal of International Business Studies, Vol. 13, No. 2 (Autumn, 1982), pp. 99-111
Published by: Palgrave Macmillan Journals
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THE BEHAVIOROF FOREIGN EXCHANGE RATES

JORGE R. CALDERON-ROSSELL*
The WorldBank

MOSHE BEN-HORIM**
Universityof Florida and Hebrew University

Abstract. The analysis of the distribution of foreign exchange rate changes provides a de-
scription of the behavior of foreign exchange rates and its determining underlyingprocess.
The application of empirical methodologies or further theoretical developments is limited
by the nature of this distribution. In this paper, the empirical analysis of major currencies
during the flexible exchange rate period suggests that there is no unique distribution repre-
senting the behavior of the foreign exchange rate. This, however, is determined both by for-
eign exchange management policies and the fundamental economic forces.

* The analysis of the distribution of foreign exchange rate changes provides INTRODUCTION
a description of the behavior of foreign exchange rates and of the underlying pro-
cess determining foreign exchange rate. From the investor's point of view, the
specification of this distribution is very helpful in assessing the riskiness of for-
eign exchange holdings. The form of the distribution and the parameters that de-
scribe it suggest the risk of investing in foreign assets. The probability of gaining
or losing in foreign exchange transactions depends on the assumed distribution,
while the sample variance, often used to reflect the variability of foreign ex-
change rates, might not be an adequate measure of risk. The sample variance is
meaningless, for example, in the case of the symmetric stable Paretian distribu-
tion. Thus, in the event that foreign exchange rate changes follow a symmetric
stable Paretian distribution, mean-variance models could be of limited use in
analyzing foreign exchange transactions. The effectiveness of portfolio diversifi-
cation strategies would also be conditioned by the characteristic exponent of the
distribution. The predictability of foreign exchange rates is, in addition, deter-
mined by the underlying probability models that best describe the behavior of for-
eign exchange rate changes.
More generally, the authors' findings on the probability distribution of exchange
rate changes might influence theoretical foreign exchange rate modeling; in ad-
dition, these findings might rule out the use of some empirical methodologies-for
example, the application of simple regression techniques to non-normal probabil-
ity distributions might produce misleading results and would not be appropriate.
Regarding the underlying process governing the behavior of the foreign ex-
change rate, the probability distribution might be indicative of the policies pur-
sued by monetary authorities and, to some extent, of their effectiveness. The
study of the distributions of foreign exchange rate changes could, therefore, be

*Jorge R. Calderon-Rossell is a staff member of the World Bank and has been a faculty
member of Columbia University and the University of Florida. He has published mainly in
the areas of international finance and financial economics. Dr. Calderon-Rossell has also
served as advisor to public and private financial institutions.
**Moshe Ben-Horimis Associate Professor of Finance in the College of Business Adminis-
tration, University of Florida. He is also at the School of Business Administration, the
Hebrew University. Dr. Ben-Horimhas consulted for governments and public utilities and
has written articles on finance and statistics.
The authors began this paper during their appointments at the University of Florida,
Gainesville. They wish to thank Richard Levich for a number of valuable comments on an
earlier draft and to acknowledge the helpful assistance of Teri Blunt in computer program-
ming. The views reported here are those of the authors and do not necessarily reflect those
of the institutions named above.

Journal of International Business Studies, Fall 1982 99

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 helpful for governments when they are formulating their foreign exchange man-
agement policies.
In studying the distribution of daily U.S. dollar prices of the Canadian dollar, the
French franc, and the British pound during the relatively flexible exchange rate
periods of the 1920s and 1970s (up to 1974), Giddy and Dufey found evidence
of non-normality of the distribution of exchange rate changes while reporting
changes of the variance over time [10, p. 21]. The distributions had longer tails
than those of the normal, and some degree of leptokurtosis. Analyzing the U.S.
dollar daily value of the German Deutsche Mark,the British pound, and the Cana-
dian dollar during 1 April 1973-27 April1975, Burtet al. [3] also found a strong de-
gree of leptokurtosis in the distribution of exchange rate changes while claiming
evidence of stationarity. Westerfield [20] studied the weekly foreign exchange
rates of the Canadian dollar, the British pound, the Deutsche Mark, the Swiss
franc, and the Dutch guilder during the fixed exchange rate regime of the 1960s
and the floating regime of the 1970s. From her application of techniques similar
to those applied to stock prices, Westerfield suggests that the symmetric non-
normal stable Paretian distribution is the best model to describe the variability of
foreign exchange rates. More recently, Rogalski and Vinso [17], using Wester-
field's sample, have offered the Student t-distribution with approximately 3.9 de-
grees of freedom as another alternative.
The purpose of this study is to present an empirical analysis of the probability
distribution of daily foreign exchange rate changes. The authors have extended
the previous studies to include 14 major currencies, focusing on the period 1 July
1974 to 29 July 1977.1 During this period the variability of the flexible foreign ex-
change rates tended to stabilize after a period of erratic fluctuations that followed
the breakdown of the Smithsonian Agreement in 1973. [See 1, p. 688.] In the
1977-1978 period, however, the variability of foreign exchange rates increased
again to the 1973 levels.
Several previous studies [10, 17, and 20] measured exchange rate movements as
the natural logarithm of exchange price relatives; however, Burtet al. [3] analyzed
discrete percentage exchange rate changes. For small exchange rate changes,
the two methods produce nearly identical results. The authors selected the dis-
crete formulation in which the daily foreign exchange rate change for country i, xi
is defined as2:

1 - r,t (1)
X riri,,t+
t+ ri,t for i = 1,2,3,...14, (1)
ri,t
where: xi = daily foreign exchange rate change of currency i;
ri,t = daily foreign exchange rate of currency i at day t, expressed as
U.S. dollars per foreign currency i unit; and
ri,t+ 1 = daily foreign exchange rate of currency i at day t + 1 expressed
as U.S. dollars per foreign currency i unit.
Under the assumption of stationarity of the distribution of foreign exchange rate
changes, the analysis of daily changes can be extended to changes between dif-
ferent holding periods or extended investment horizons. In this paper, however,
the focus is only on the one-day holding period. In addition, given that the form of
the quotation does not determine the nature of the probability distribution of for-
eign exchange rate changes, a direct quotation of the foreign exchange rate is
used where the unit of account is the U.S. dollar. Therefore, positive values for xi
indicate appreciation of foreign currency i vis-a-vis the U.S. dollar, whereas nega-
tive values signal a depreciation of the foreign currency i. Under equilibrium con-
ditions the standardized distribution of foreign exchange rate changes expressed
in the indirect quotation would be the mirrorimage of the standardized distribu-
tion of the rate changes expressed in the direct quotation.

100 Journal of International Business Studies, Fall 1982

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In the next section, the skewness of xi's distribution is analyzed. Differences in
the skewness of the distribution have been found among groups of currencies. In
the third section, the stationarity of the distribution is examined and an attempt
is made to reveal the source of the lack of stationarity. Penultimately, the stable
Paretian distribution hypothesis is tested and some conclusions are drawn in the
last section.

One of the major characteristics of the nature of a probability distribution is its SKEWNESS
degree of asymmetry, or departure from symmetry. The analysis of the symmetry
of the probability distributions of foreign exchange rate changes is based on the
skewness statistic:
Numberof observations below the mean
Sk=( -1/2) 2n, (2)
n
where n is the numberof sample observations.3 For large samples this statistic is
normally distributed with mean 0 and variance 1.
In order to analyze skewness and stationarity, the period was divided into 3 sub-
periods: 1 July 1974-30 June 1975; 1 July 1975-30 July 1976; and 2 August 1976-
29 July 1977, labeled subperiods 1, 2, and 3, respectively. For each subperiod the
14 corresponding distributions were observed. Although these subperiods of ap-
proximately 365 observations per currency are quite arbitrary,they seem to be ap-
propriate for studying the skewness and stationarity of the foreign exchange rate
in different intervals. In principle, under normal conditions and overall stationarity
of the period of analysis, which seem to characterize the period under review, any
sample subperiod is appropriate for studying variations in the skewness of distri-
butions and for examining stationarity within the period.
The value of the Sk statistic for each subperiod is presented in Table 1. Based on

TABLE 1
Skewness Statistic (Sk)

Subperiods

Group Currency 1 2 3

AustrianSchilling 0.437 -1.133 1.245

BelgianFranc 0.062 - 0.895 0.872
Canadian Dollar - 1.435 -0.298 - 1.868
DanishKrone 0.187 - 1.491 0.125
NetherlandsGuilder -0.936 -0.298 1.619
NorwegianKrone 0.437 - 1.372 0.623

DeutscheMark -0.187 - 0.060 2.241*

II French Franc 1.060 -2.088* 0.623
Swedish Krona 0.686 - 2.088* - 0.374

Australian Dollar - 7.797** - 1.849 - 5.479**

Italian Lira 0.312 -4.116** - 9.961**
III Japanese Yen 0.561 3.042** 2.988 *
Pound Sterling - 2.183** -4.116** - 0.747
Spanish Peseta 0.437 -6.741** - 10.584*

*Significant at 5%.
*Significant at 1%.

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 the skewness of the distributions, foreign currencies were classified in 3 groups.
In the first group (I),the skewness statistic Sk was not statistically different from
zero for all currencies and subperiods. Therefore, there is strong evidence to con-
clude that the distributions of all currencies in this group were symmetric during
the period of study. In the second group (II),the distribution of changes in the for-
eign exchange rate of these currencies was close to being symmetric except for
at least 1 subperiod. Three out of 9 subperiods showed some degree of skew-
ness, at a 5 percent significance level. In the case of the Deutsche Mark,skew-
ness was positive in the third subperiod, while the skewness of the French franc
and Swedish krona was negative in the second subperiod. Finally, in the third
group (III),the skewness statistic suggests strongly that all the distributions in
these groups were asymmetric. With the exception of the distribution of the Japa-
nese yen with positive asymmetry, all other distributions showed signs of nega-
tive skewness. In group III,mainly during subperiods 2 and 3, the likelihood of
Type I erroris reduced to a significance level of 1 percent, which suggests strongly
the asymmetry of the distributions of the foreign exchange rate changes classi-
fied under this group.
During the period of study, the Deutsche Markand the Japanese yen, with signs
of positive skewness, appreciated vis-a-vis the U.S. dollar, while the Italian lira,
the pound sterling, and the Spanish peseta, with a negative skewness, depreci-
ated vis-a-vis the U.S. dollar. It seems, therefore, that the skewness of the distri-
bution of foreign exchange rates is related to the trend value of the currency. This
trend might not, however, be anticipated and can be of short duration as in Group
IIcurrencies, or it can be a sustained trend as in the case of Group IIIcurrencies.
Whereas from the theoretical point of view these patterns should be the result of
economic causes, the grouping of these currencies on the skewness of the prob-
ability distributions suggests also that the management policies of foreign ex-
change rates are determining factors in the behavior of foreign exchange rates.

TABLE2
Mann-WhitneyZ Statistic for Strict Stationarity (xi)
ComparedSubperiods

Group Currency 1 versus 2 2 versus 3

Austrian Schilling 1.7450 2.0447*

Belgian Franc 2.1193* 2.8324**
Canadian Dollar 3.7108** 2.5670**
Danish Krone 2.1504* 2.0409*
Netherlands Guilder 2.7064* 2.5737*
Norwegian Krone 2.1510* 1.8441

Deutsche Mark 2.0067* 2.1184*

II French Franc 4.1950** 2.4572*
Swedish Krona 2.2087* 1.7054

Australian Dollar 1.6391 2.6725**

Italian Lira 2.6089** 1.7606
III Japanese Yen 2.5390* 1.2962
Pound Sterling 1.0872 1.5816
Spanish Peseta 2.8913** 0.16233

*Significant at 5%.
*Significant at 1%.

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After the collapse of the Bretton Woods system and subsequently of the Smith-
sonian Agreement, major currencies of industrial countries entered into a man-
aged floating system subject to different policies. Most European countries
entered into an agreement to maintain the foreign exchange rates within estab-
lished limits, while other countries such as Italy, Japan, and the United Kingdom
were following more independent policies in managing their foreign exchange
rates. Therefore, the groupings shown in Table 2 suggest that the control regime
of foreign exchange rates is a determining factor of foreign exchange behavior.
Most countries whose currencies are in Group I and II were managing their for-
eign exchange rates under the "EuropeanSnake" agreement. Although currencies
in Group IIshow some short duration drifts, they are very close to the symmetry
shown by Group I currencies. On the other hand, Group IIIcurrencies were follow-
ing more independent foreign exchange regimes. Although the literature has paid
attention to policy prescriptions for different management approaches in ex-
change rates, empirical research has basically neglected these different policies
in managing the "dirtyfloat." Evidently, based on the preceding discussion, both
the economic causes of foreign exchange rate determination and the policies for
managing the foreign exchange rate are important factors determining its actual
behavior.The differences between Group I and II,and Group IIIcurrencies indicate
a substantial difference in foreign exchange adjustments. Nevertheless, the
grouping of skewed distributions seems to support the policies for managing the
foreign exchange rate as the most plausible explanation determining the behav-
ior of foreign exchange rates. Economic forces would have an effect on this
behavior under the guidelines and policies established by monetary authorities.
Evidently, this situation implies some effectiveness of governments' control of
foreign exchange markets. The extent of this control vis-a-vis the underlying eco-
nomic forces is still a subject for further research.

The analysis of skewness presented in Section IIimplies some differences in the STATIONARITY
stationarity of the probability distributions between the groups of currencies and,
probably, of the underlying process determining foreign exchange rates. Whereas
currencies of Group I appear to have symmetric distributions in each subperiod,
therefore suggesting stationarity, the distribution of currencies of Groups IIand
IIIchanged skewness between subperiods, with currencies of Group IIIshowing
more definite trends. In general, if the probability distribution is strictly station-
ary, then parameter values estimated-with data from period k will be statistically
consistent with parametervalues for period j. Stationarity permits us to make prob-
ability assessments of the future value of the foreign exchange rate based on pa-
rameter estimates from past data. Because of all this, a more in depth analysis of
stationarity is necessary.
Strict stationarity4 is defined in terms of the probability function as:
P(xt,... ,xt + k) = P(xt + m, . . . ,t + k + m), (3)
where t is any point in time, and k and m are any pair of integers.5 The Mann-
Whitney U test6 between consecutive subperiods was applied to test for strict
stationarity. These results are shown in Table 2. The grouping of currencies in
this table and hereafter follows the same classification as in Table 1.
Based on the evidence shown in Table 2, the hypothesis that the probability dis-
tributions did not change from one subperiod to the next was rejected. With
the exception of the pound sterling, the distribution of foreign exchange rate
changes varied at least once between consecutive subperiods at the 5 percent
significance level. Distributions of currencies in Groups I and II,however, showed
more variations than those of Group III.Whereas in the first two groups the distri-
butions changed between every subperiod, in the third group the distributions

Journal of International Business Studies, Fall 1982 103

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 changed only once. Again this pattern seems to reflect the differences in foreign
exchange policies pursued by monetary authorities of the respective countries.
The asymmetry of the distributions and their relative stationarity, in particular
during subperiods 2 and 3, seem to suggest that countries of Group IIIcurrencies
were either more consistent in their policies or subject to more persistent eco-
nomic forces than those in the other groups. Given that government policies and
controls are likely, however, to be bound by the economic forces determining equi-
libriumforeign exchange rates, noticing the currencies included in Group IIIthat
were subject to a continuous pressure to depreciate or appreciate during the pe-
riod of analysis, and observing furtherthe asymmetry of these currencies (Table 1),
it is plausible to infer that within the period of the study, governments from coun-
tries with currencies in Group IIIwere trying to restrain the underlying economic
forces determining foreign exchange rates. This implies that foreign exchange
rates of currencies in Group IIIduring the period of analysis could have been sub-
ject to more stringent controls or government interventionrelative to the economic
forces governing them.
The lack of strict stationarity may, however, be the result of changes in at least
one of the parameters of the distribution. In order to examine stationarity of the
mean and standard deviation, additional tests for each of the currencies were con-
ducted. For this, the following transformed variables were examined:
yi = xi- Xi, (4)
and
W = Xi/Si. (5)
By performing Mann-WhitneyU tests on yi, and wi, one can indirectly assess the
effect of changes in the mean and/or the standard deviation on strict stationarity.7
If, for example, the U test on xi shows that a given distribution has changed be-
tween 2 subperiods, but the test on yi shows no significant change between the
same subperiods, the conclusion will be that it is the shift in the mean of the dis-
tribution that was the main cause of the change in the distribution of xi. On the
other hand, if both xi and yi changed between subperiods, it may be concluded that
the change in xi was caused by changes of parameters other than the mean of the
distribution. Similarly, if xi changed between subperiods, but wi = xi/si did not, the
change in the standard deviation of the distribution of xi is suggested to be the
main cause of the change in the distribution of xi. If both xi and wi show signif-
icant changes between subperiods, the change in xi was caused by changes of
parameters other than the standard deviation.
The result of the Mann-WhitneyU tests on yi and wi are exhibited in Tables 3 and 4.
From contrasting the results of Tables 2 and 3, it is found that when the effect of
the change in the mean was removed (equation 4), the currencies in Groups I and II
showed a marked drop in the Mann-WhitneyZ value, meaning that the major fac-
tor contributing to the high Z values for xi (Table 2) for the currencies in Groups I
and IIwas shifts in the means of the distributions between subperiods. Supporting
evidence for this conclusion is also derived from Table 4, where the Z values of the
Mann-Whitneytests of wi = xi/si are presented. By contrasting the results of Ta-
bles 2 and 4, we find that the values in Groups I and IIare remarkablyclose, indicat-
ing that the sample standard deviation of these currencies was relativelystationary
through the 3 subperiods. The tests for the few currencies in Group IIIthat showed
lack of strict stationarity were rathermixed. However,from examining Tables 1 and
2, it is evident that the lack of strict stationarity exhibited by some of the currencies
of GroupIIIis mainly the result of changes in the skewness of these distributions.
Once more these findings point to the policies of foreign exchange management
followed by monetary authorities of the respective countries in combination with
the underlying economic forces as the major explanation for the behavior of the

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 TABLE 3
Mann-Whitney Z Statistics for y'

Compared Subperiods

Group Currency 1 versus 2 2 versus 3

Austrian Schilling .1673 .8532

Belgian Franc .8073 .2108
Canadian Dollar .1878 .8972
Danish Krone .0928 .0181
Netherlands Guilder .4804 .7730
Norwegian Krone .3209 .8523

Deutsche Mark .2717 .7220

II French Franc .5666 1.5378
Swedish Krona .6024 .4996

Australian Dollar 3.7918** 5.2652**

Italian Lira 1.7742 4.1655**
IIl Japanese Yen .6043 1.4269
Pound Sterling .6753 2.0083*
Spanish Peseta 3.4005** 2.6453**

*Significant at 5%.
*Significant at 1%.

TABLE 4
Mann-Whitney Z Statistic for wi

Compared Subperiods

Group Currency 1 versus 2 2 versus 3

Austrian Schilling 1.6607 2.0582*

Belgian Franc 2.0092* 2.8807**
Canadian Dollar 3.7296** 2.6428*
I Danish Krone 2.1300* 2.0343*
Netherlands Guilder 2.6001** 2.5668**
Norwegian Krone 2.0609* 1.8361

Deutsche Mark 1.7877 2.1678*

II French Franc 4.1519* 2.1676*
Swedish Krona 2.1893* 1.7353

Australian Dollar 1.4598 1.7115

Italian Lira 2.1655* 1.6524
III Japanese Yen 1.6720 1.1651
Pound Sterling 1.2167 1.6104
Spanish Peseta 2.5709** 2.4554*

*Significant at 5%.
*Significant at 1%.

Journal of International Business Studies, Fall 1982 105

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 distribution of foreign exchange rate changes. After the breakdown of the Smith-
sonian Agreement, most currencies in Groups I and II entered into a new agree-
ment to maintain the currencies of their respective currencies floating under a
band, the "European Snake." Based on the evidence shown above, currencies of
those countries were changing mean between subperiods while the sample stan-
dard deviation remained unchanged. The stationarity of the standard deviation of
the European currencies would suggest that the snake arrangement permitted
the effective control of the dispersion of the foreign exchange rates but not nec-
essarily of their overall level. On the other hand, countries of Group IIIcurrencies
subject to major economic forces that were continuously exerting pressure on
the level of the rates were probably actively intervening in the foreign exchange
market to restrain further changes in their foreign exchange rates. Countries of
currencies in GroupIIIappear to have been holding up the overall mean of the prob-
ability distribution while facing continuous drifts that made them asymmetric.
In summary, the distribution of foreign exchange rate changes of Groups I and II
can be characterized to be symmetric, subject to location shifts-that is, changes
of the mean-and to have a constant sample standard deviation (or variance). On
the other hand, distributions in Group IIIare asymmetric and mostly stationary. In
the few instances where these distributions shifted, it was the result of changes
in the skewness of the distribution.

STABLE Studying the behavior of security and commodity prices, Mandelbrot [13] ques-
PARETIANtioned the Gaussian hypothesis and offered the "Stable Paretian Distributions"
DISTRIBUTIONS as an alternative. Extendingeven furtherthe analysis of these distributions, Fama
and Roll examined the behavior of stock prices [6, 7, 8] and of interest rates [18].
Westerfield [20] used similar techniques for the analysis of foreign exchange rate
behavior. Rogalski and Vinso [17] proposed the Student "t" distribution with ap-
proximately 3.9 degrees of freedom as an alternative description for the floating
period of the 1970s. This distribution, however, theoretically has a coefficient of
kurtosis lower than the normal while the moment coefficient of kurtosis is unde-
fined. Therefore, the Student "t" distribution around 3.9 degrees of freedom has a
lower peakedness than the normal and fails to explain the high peakedness of
the empirical distributions of foreign exchange rate changes reported in other
studies. Because of this, only the stable Paretian hypothesis is examined for this
sample of 14 currencies.
In general, the stable Paretian family of distributions is defined by the logarithm
of the characteristic function (that is, the second characteristic function of the
random variable x):
logekx (t)= log e [ I eitXdF(x)]=i6t-yltl|[1 + i /(t/ltl)tan (ovr/2)]
-00
(6)
where x is the random variable, i is - 1, t is a real number, and F is the cumula-
tive distribution function. The rest of the parameters are those of the stable Pare-
tian distribution:the characteristic exponent oc(0< oc< 2), the location parameter
6 (the mean when oc>1), the index of skewness 0(- 1 <fi + 1), and the scale pa-
rameter c, (y = c)).
For the symmetric case (, = 0), the logarithm of the characteristic function is:
logexx(t) = it - yltl (7)
The characteristic exponent oc defines a particulardistribution among the stable
Paretian family. When oc=2, the relevant stable Paretian distribution is the nor-
mal distribution, whereas when oc= 1, the distribution is the Cauchy distribution.
In the interval 0< oc<2, the tails of the stable Paretian are thicker than those of
the normal distribution. In this interval the variance does not exist (that is, is not
defined), while the mean exists as long as oc> 1.

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Westerfield [20] suggested that foreign exchange rate changes during the float-
ing period of the 1970s followed a symmetric stable Paretian distribution with
characteristic exponent in the interval1 < oc<2, more precisely close to 1.4. There-
fore, the Kolmogorov-Smirnovstatistic8 to test the hypothesis that the distribu-
tions are indeed stable Paretian was applied to each one of the 14 currencies over
the entire period of analysis: 1 July 1974 through 29 July 1977. For the theoretical
distribution the authors used the Fama and Roll [7] tables for standardized sym-
metric stable distributions for 12 different values of oc in the interval 1 < oc<2.
The Kolmogorov-Smirnovtest9 was performed for the 12 values of the character-
istic exponents previously selected. The values of the test statistic for c = 1.0,
o= 1.5, and oc=2.0 are presented in Table 5. The evidence seems to suggest
again that the behavior of the foreign exchange rate changes varies between cur-
rencies. The results for the currencies in Groups I and IIlend support to previous
findings that the returnsdistributions are stable Paretian with characteristic expo-
nent 1 < c <2; the hypothesis that oc= 1.5 could not be rejected at the 5 percent
level for any of these currencies, while the hypotheses that oc= 1.0 and oc= 2.0
were rejected in most cases at 5 percent significance level. As the table shows,
however, the currencies in Group IIIdiffer significantly in their distributions of
the foreign exchange rate changes. Using the Kolmogorov-Smirnovtest, the au-
thors rejected the null hypothesis for the currencies in Group IIIat the 1 percent
significance level and concluded that these returnsdistributions are not symmetric
stable Paretian. Based on the fourth moment (available upon request), as reported
in other studies, the distributions of the currencies in Group IIIhave exhibited a
high degree of leptokurtosis, substantially greater than the stable Paretian dis-
tributions, while showing also a high.degree of asymmetry. Perhaps these distri-
butions could still be stable Paretian but of the asymmetric family. Testing this
hypothesis, however, would requirethe theoretical development of the parameters

TABLE 5
Kolmogorov-SmirnovStatistic: DI max

Hypotheses

Ho:a = 1 (Cauchy) Ho:a = 1.5 Ho:a =2 (Normal)

Group Currency Hi: a 1 Hi: a 1.5 Hi: ac2

Austrian Schilling 4.99* 3.07 5.71*

Belgian Franc 4.33 2.58 5.35*
Canadian Dollar 4.96* 2.22 3.63
Danish Krone 5.36* 2.43 5.07*
Netherlands Guilder 5.16* 2.95 5.59*
Norwegian Krone 4.45 1.45 4.34

Deutsche Mark 5.57* 2.43 5.07*

II French Franc 5.99** 4.65 7.08**
Swedish Krona 4.89* 2.95 5.59*

Australian Dollar 17.42** 17.46** 17.40**

Italian Lira 16.95** 16.97** 16.91**
III Japanese Yen 8.61* 8.63** 8.58**
Pound Sterling 11.83** 11.86** 11.85**
Spanish Peseta 16.29** 16.09* * 16.0**

*Significant at 5%.
*Significant at 1%.

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 of those distributions that are not yet available. Nevertheless, the differences be-
tween the probability distributions reported here provide evidence regarding the
different behavior of foreign exchange rates under different foreign exchange
policies and underlying economic forces.

CONCLUSIONS
The analysis of the empirical probability distribution of fourteen daily foreign ex-
change rate changes during the flexible exchange rate period leads to two major
generalizations: (1) there is no unique distribution that represents the behavior of
the foreign exchange rate of major currencies; and (2) the evidence seems to sug-
gest that the behavior of foreign exchange rates is strongly determined by both
the foreign exchange rate management policies pursued by the monetary author-
ities of the respective countries and the underlying economic forces determining
foreign exchange rates.
In this study, 14 major currencies could be classified under two major broad
groups representing two basic distinct foreign exchange rate management poli-
cies. The first major group (I and II)is characterized by symmetric distributions,
nonstationarity of the mean, almost stationary sample variance, and most likely
following a symmetric stable Paretian model with a characteristic exponent close
to oc= 1.5. The second major group (III)is characterized, however, by almost sta-
tionary asymmetric distributions, and following other than a symmetric stable
Paretian distribution.
During the sample period most countries of currencies in the first major group (I
and II)were following a foreign exchange rate policy designed to restrict exchange
rate variabilityto predeterminedlimits-that is, the "EuropeanSnake" agreement.
On the other hand, countries of currencies in the second major group (III)were at-
tempting to restrain further drifts of the foreign exchange rate while facing sub-
stantial economic pressures to adjust toward equilibrium rates.
In analyzing covered interest arbitrage Frenkel and Levich [9] suggest classifying
periods by the degree of turbulence rather than by the legal arrangement of the
exchange rate regime. Although the analysis of the behavior of foreign exchange
rate changes discussed in this paper is made underthe same legal arrangementof
the exchange rate regime, the results show-similarly to the Frenkel and Levich
study-a different behavior between groups of currencies that were subject to a
different "degree of turbulence." This turbulence has been associated here with
the underlying economic forces determining foreign exchange rates and the gov-
ernments' policies for its management. In addition to these differences between
currencies, some variations of these factors were also evident within the period
or subperiods analyzed for each currency.
The apparent differences between the probability distribution of foreign ex-
change rate changes reported here seem to suggest also that unless some com-
pensatory factors modifying the structure of foreign exchange distributions are
present, some degree of segmentation may exist in foreign exchange markets.
The differences in the groups of currencies would imply a characterizationbetween
segments of the foreign exchange market. Nevertheless, to study this segmenta-
tion hypothesis further,an acceptable theory of international markets integration
needs to be developed.
From the investor's point of view, the currencies of interest need to be examined
in light of the foreign exchange rate management policies pursued by the respec-
tive monetary authorities relative to the underlying economic forces. Under the
flexible exchange rate assumption, this is an additional dimension to the foreign
exchange risk. Monetary authorities might resort to different foreign exchange
rate policies which could modify the behavior of foreign exchange rates. Disre-
garding this new element of risk, usually neglected in the empirical literature, in-

108 Journal of International Business Studies, Fall 1982

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vestors would need to assess their strategies in dealing with currencies underthe
two major groups. The evidence seems to indicate that currencies in the first ma-
jor Group (I and II)within boundaries are allowed to follow floating rates. These
rates, however, do not follow a stationary process. Therefore, for an investor par-
ticipating in these markets, it may be a fair, but extremely risky, game. Although
the sample variance is stationary, this is irrelevant if the distribution follows a
symmetric stable model with a characteristic exponent around a= 1.5 that does
not have a defined variance. In addition, the location of the distribution is subject
to continuous shifts. Under these circumstances, any forecasts and actual rates
would coincide only by chance.
On the other hand, investing in currencies in the second major group (III),with the
skewness of their distribution, would be similar to entering in a biased game.
Although theoretical arguments could be advanced to further discuss biases of
skewed distributions, empirical research would be necessary to recommend par-
ticular investment strategies. Nevertheless, it is expected that investors would
decide whether or not to engage in these markets depending upon the risk aver-
sion of the investor and the nature of the asymmetry of the distribution. If other
factors held constant (for example: international interest rates), currencies with
negative means and negative asymmetry would be avoided, except by risk-lovers,
while currencies with positive means and positive asymmetry would be preferred.
In this case, the tendency of these currencies seems to be more amenable to a
forecasting exercise.
Besides the behavior of foreign exchange rates, however, the analysis of invest-
ment opportunities needs to take into account other factors which have been
omitted here. The pay-off of the investment, the value judgment, horizon period,
portfolio, and consumption preferences, and the time value of money or foreign
exchange are some additional factors that would have to be taken into account in
assessing investment opportunities of foreign exchange markets.
The actual behavior of the foreign exchange market, in general, has eluded the
ideal theoretical assumptions undertaken in the literature.The fact that the Inter-
national Monetary System was fragmented after the collapse of the Bretton
Woods system and the breakdown of the Smithsonian Agreement has not been
fully explored in the empirical literature. Different policies for managing the for-
eign exchange rate bounded by the underlying economic forces appear to result
in different probability distributions of foreign exchange rates. Serious doubts
are raised, therefore, regarding empirical studies developed under the assump-
tion of the traditional normal distributions of foreign exchange rate changes.
Mean-variance models might have led to misleading results. In future research,
the simple extension of stock market analysis to the behavior of foreign ex-
change markets needs to be justified and analyzed to account for the major fac-
tors that intervene in the international arena. Thus, because the current behavior
of foreign exchange markets remains elusive, furtherwork is called for on foreign
exchange rate determination models that will enhance our understanding of in-
ternational financial markets.

1. A data file of about800 dailyexchangerateswas developedforeach of 14 currenciesre- FOOTNOTES

portedin the InternationalFinancialStatistics, publishedby the InternationalMonetary
Fund. These daily exchange rates are the market rates of the respective countries. The
South African Rand was excluded because its behavior is a de facto adjustable fixed ex-
change rate.
2. The discrete formulation imparts a small upward bias to the percentage change calcula-
tion; for example, if an exchange rate moves from 1.00 to 1.01 and back to 1.00 in two days,
the average change, is 0.0 percent when the calculation is based on the logarithm of ex-
change rate relatives. The average daily change is 0.005 percent when the calculation is
based on discrete exchange rate changes. This difference is insignificant. Furthermore,
most of our exchange rate movements are less than 1.0 percent. For $(ri,t),the U.S. investor

Journal of International Business Studies, Fall 1982 109

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 can purchase one money unit of currency i on day t. On day (t + 1) he can convert back and
get $(ri,t+1).Thus this rate of returnfor the day in xi as defined earlier.
3. Roll [18], p. 74.
4. The concepts of stationarity and stability have to be distinguished with respect to the
stable Paretian distributions. Stationarity implies no changes in any of the parameters of
the distribution, while stability is specifically related to no changes in the characteristic
exponent of the stable Paretian distribution.
5. Nelson [15], p. 20.
6. When dealing with two or more empiricaldistributions,the Mann-Whitneytest is the most
appropriate [Siegel 19, p. 136]. The test is based on the U statistic which is determined by
the numberof cases, ni and n2,of each sample and the sum of the ranks, R1and R2,of each
sample. The sampling distribution of U approaches the normal distribution. For more on
this test see Conover [4] or Siegel [19].
7. A direct test of the mean will be to use the Mann-WhitneyTest assuming that any differ-
ence between the distribution functions is a difference in the location of the distribution.
[See Conover 4, page 225.] However, this direct approach is based on an assumption that
has to be proved;therefore, to find further evidence of the shifts in the mean the authors
developed the tests for the transformed variable, yi.
8. The Kolmogorov-Smirnovtest is one of the most powerful goodness-of-fit tests when an
empirical distribution is compared with an hypothesized theoretical distribution. Contrary
to the chi-square test, the Kolmogorov-Smirnovtreats individual observations separately,
therefore, it does not lose information through the combining of categories. Because of
this the Kolmogorov-Smirnovtest may be in all cases more powerful than the chi-square
test. [See Siegel (19), p. 51].
9. The tests were performedon the standardized variables
xi - ui
Uj
Cii-
where ui is the mean of the empirical distribution.The results of these tests are reported in
Table 5. In addition, we used the standardized variables

U= Xi-6i
Ci

where 6i is the .5 truncated mean, as was suggested by Fama and Roll [7].Although this ap-
proach could be subject to debate, the authors disregard it considering that the results
were very close to those reported in Table 5.

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