| This dissertation studies the distortionary effects of high inflation on two forward exchange markets, the German Reichsmark/British Pound market during the German hyperinflation of 1921-23, and the Brazilian Cruzeiro/U.S. dollar market before the Real Stabilization of July 1994. Two distortions are found in analyzing the data: a risk premium in the forward rate that is proportional to the volatility of inflation, and the thinning of the forward market, leading to its disappearance under hyperinflation. We test the evidence against a simple efficiency hypothesis, under the assumption of risk neutrality and risk aversion, and find mixed support for efficiency. We then turn to analyzing the covered interest parity condition, and find differing results. In the German case, there is no clear violation of the arbitrage condition, whereas in the Brazilian case, there is an apparent violation of arbitrage, which increases with the rate of inflation. The apparent violation is subsequently explained by the default risk in holding the Brazilian asset considered. We also find no definite support for the so-called 'Peso-problem'--the effects of a future stabilization on the pricing of forward contracts. We then consider the theory of backwardation, as first postulated by Keynes and Hicks. We trace its historical development in the literature and consider its applicability to forward exchange markets. We show that, while the theory would not apply under stable monetary conditions, there are reasons to suggest that it applies to conditions of high inflation. We study a simple intertemporal rational expectations model and show under what conditions the model exhibits backwardation. We simulate the model under various conditions of monetary instability and find that it can match the two stylized facts of the data, namely, a risk premium proportional to the volatility of the exchange rate, and the thinning of the market leading to its disappearance. Finally, we suggest the applicability of the theory of backwardation to the effects of inflation on other intertemporal markets, which could lead to a more general theory of the relationship between inflation and financial deepening. |