Measuring the Degree of Currency Misalignment Using Offshore Forward Exchange Rates: The Case of the Korean Financial Crisis

This paper proposes a new method of measuring the degree of currency misalignment through the use of offshore forward exchange rates. Using default risk adjusted no­arbitrage conditions for forward exchange contracts, we calculate the spot exchange rates and the domestic interest rates that are implied from the observed forward exchange rates. The difference between the implied and the observed spot exchange rates is our measure of currency misalignment. Our methodology is based on the presumption that, during a currency crisis, offshore forward exchange rates reflect market sentiments more closely than onshore spot and forward exchange rates. The latter are usually tightly regulated and heavily affected by government intervention during a non­normal event such as a financial crisis. We apply the method to the Korean financial crisis in 1997 and discuss its implication for evaluating the IMF adjustment program and explaining foreign capital flows.