Exchange Rate Determination

Chapter 10
Foreign Exchange Rate Determination and Forecasting
Copyright 2010 Pearson Prentice Hall. All rights reserved.
Foreign Exchange Rate Determination

Exchange rate determination is complex. The following exhibit provides an overview of the many determinants of exchange rates. This road map is first organized by the three major schools of thought (parity conditions, balance of payments approach, asset market approach), and secondly by the individual drivers within those approaches. These are not competing theories but rather complementary theories.
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Foreign Exchange Rate Determination

Without the depth and breadth of the various approaches combined, our ability to capture the complexity of the global market for currencies is lost. In addition to gaining an understanding of the basic theories, it is equally important to gain a working knowledge of:
the complexities of international political economy; societal and economic infrastructures; and, random political, economic, or social events affect the exchange rate markets.
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Exhibit 10.1 The Determinants of Foreign Exchange Rates
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Exchange Rate Determination: The Theoretical Thread

The previous exhibit, with its tripartite categorization of exchange rate theory is a good start but in our humble opinion is not robust enough to capture the multitude of theories and approaches. Therefore, in the following slides, we will introduce several additional streams of thought.
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The theory of purchasing power parity is the most widely accepted theory of all exchange rate determination theories:
PPP is the oldest and most widely followed of the exchange rate theories. Most exchange rate determination theories have PPP elements embedded within their frameworks. PPP calculations and forecasts are however plagued with structural differences across countries and significant data challenges in estimation.
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The balance of payments approach is the second most utilized theoretical approach in exchange rate determination:
The basic approach argues that the equilibrium exchange rate is found currency flows match up vis a vis current and financial account activities. This framework has wide appeal as BOP transaction data is readily available and widely reported. Critics may argue that this theory does not take into account stocks of money or financial assets.
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Exchange Rate Determination: The Theoretical Thread The monetary approach in its simplest form states that the exchange rate is determined by the supply and demand for national monetary stocks, as well as the expected future levels and rates of growth of monetary stocks. Other financial assets, such as bonds are not considered relevant for exchange rate determination, as both domestic and foreign bonds are viewed as perfect substitutes.
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Exchange Rate Determination: The Theoretical Thread The asset market approach argues that exchange rates are determined by the supply and demand for a wide variety of financial assets:
Shifts in the supply and demand for financial assets alter exchange rates. Changes in monetary and fiscal policy alter expected returns and perceived relative risks of financial assets, which in turn alter exchange rates.
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Exchange Rate Determination: The Theoretical Thread The forecasting inadequacies of fundamental theories has led to the growth and popularity of technical analysis, the belief that the study of past price behavior provides insights into future price movements. The primary assumption is that any market driven price (i.e. exchange rates) follows trends.
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The Asset Market Approach to Forecasting

The asset market approach assumes that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations or drivers (among others): Relative real interest rates Prospects for economic growth
Capital market liquidity

A countrys economic and social infrastructure Political safety Corporate governance practices Contagion (spread of a crisis within a region) Speculation
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The Asset Market Approach to Forecasting

Foreign investors are willing to hold securities and undertake foreign direct investment in highly developed countries based primarily on relative real interest rates and the outlook for economic growth and profitability. The asset market approach is also applicable to emerging markets, however in these cases a number of additional variables contribute to exchange rate determination (previous slide).
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Disequilibrium: Exchange Rates in Emerging Markets

Although the three different schools of thought on exchange rate determination (parity conditions, balance of payments approach, asset approach) make understanding exchange rates appear to be straightforward, that it rarely the case. The large and liquid capital and currency markets follow many of the principles outlined so far relatively well in the medium to long term.
The smaller and less liquid markets, however, frequently demonstrate behaviors that seemingly contradict the theory.
The problem lies not in the theory, but in the relevance of the assumptions underlying the theory.
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Illustrative Case: The Asian Crisis

The roots of the Asian currency crisis extended from a fundamental change in the economics of the region, the transition of many Asian nations from being net exporters to net importers. The most visible roots of the crisis were the excess capital inflows into Thailand in 1996 and early 1997. As the investment bubble expanded, some market participants questioned the ability of the economy to repay the rising amount of debt and the Thai bhat came under attack.
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The Thai government intervened directly (using up precious hard currency reserves) and indirectly by raising interest rates in support of the currency. Soon thereafter, the Thai investment markets ground to a halt and the Thai central bank allowed the bhat to float. The bhat fell dramatically and soon other Asian currencies (Philippine peso, Malaysian ringgit and the Indonesian rupiah) came under speculative attack.
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The Asian economic crisis (which was much more than just a currency collapse) had many roots besides traditional balance of payments difficulties:
Corporate socialism
Corporate governance Banking liquidity and management
What started as a currency crisis became a region-wide recession.

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Exhibit 10.3 Comparative Daily Exchange Rates: Relative to U.S. Dollar
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Illustrative Case: The Argentine Crisis of 2002

In 1991 the Argentine peso had been fixed to the US dollar at a one-to-one rate of exchange. A currency board structure was implemented in an effort eliminate the source inflation that had devastated the nations standard of living in the past.
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By 2001, after three years of recession, three important problems with the Argentine economy became apparent:
The Argentine Peso was overvalued
The currency board regime had eliminated monetary policy alternatives for macroeconomic policy
The Argentine government budget deficit and deficit spending was out of control
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In January 2002, the peso was devalued as a result of enormous social pressures resulting from deteriorating economic conditions and substantial runs on banks. However, the economic pain continued and the banking system remained insolvent. Social unrest continued as the economic and political systems within the country collapsed; certain government actions set the stage for a constitutional crisis.
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Exhibit 10.6 Daily Exchange Rates: Argentine Pesos per U.S. Dollar
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Forecasting in Practice
Technical analysts, traditionally referred to as chartists, focus on price and volume data to determine past trends that are expected to continue into the future. The single most important element of technical analysis is that future exchange rates are based on the current exchange rate. Exchange rate movements can be subdivided into three periods: Day-to-day Short-term (several days to several months) Long-term
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Forecasting in Practice
The longer the time horizon of the forecast, the more inaccurate the forecast is likely to be. Whereas forecasting for the long run must depend on the economic fundamentals of exchange rate determination, many of the forecast needs of the firm are short to medium term in their time horizon and can be addressed with less theoretical approaches.
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Forecasting: What to Think?

It appears, from decades of theoretical and empirical studies, that exchange rates do adhere to the fundamental principles and theories previously outlined. Fundamentals do apply in the long term There is, therefore, something of a fundamental equilibrium path for a currencys value.
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Forecasting: What to Think?

It also seems that in the short term, a variety of random events, institutional frictions, and technical factors may cause currency values to deviate significantly from their long-term fundamental path. This behavior is sometimes referred to as noise. Therefore, we might expect deviations from the long-term path not only to occur, but to occur with some regularity and relative longevity.
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Exhibit 10.8 Differentiating Short-Term Noise from Long-Term Trends
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Exhibit 10.9 Exchange Rate Dynamics: Overshooting
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Technical Analysis
An attempt to exploit recurring and predictable patterns in stock prices Technicians beliefs:
Shifts in market fundamentals can be discerned before their impact is fully reflected in prices Market fundamentals can be perturbed by irrational factors
These presumptions are in contradiction with the weak form of the EMH
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Term Spread: A Leading Technical Indicator
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Trends and Charting

The Dow theory
Primary trend Secondary or intermediate trends Tertiary or minor trends Support and resistance levels
Recent variations
The Elliot wave theory The theory of Kondratieff waves
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Dow Theory Trends
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Actual and Simulated Levels for Stock Market Prices of 52 Weeks (Figure 11.7)
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Actual and Simulated Levels for Stock Market Prices of 52 Weeks (Figure 11.8)
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Price Charts
Moving averages Bollinger bands MACD (moving average convergence/divergence) Stochastic indicator (oversold/bought) Volume
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Moving Averages
Average calculated on last n periods such as 200-day or 50-day Price or shorter average crossing the longer average is said to predict a change in direction
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Moving Average for Microsoft
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Chart of CNQ (unauthorized)
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Mini-Case Questions: JP Morgan Chases Forecasting Accuracy How would you actually go about calculating the statistical accuracy of these forecasts? Would Vesi have been better off using the current spot rate as the forecast of the future spot rate, 90 days out? Forecasting the future is obviously a daunting challenge. All things considered, how well do you think JPMC is doing? If you were Vesi, what would you conclude about the relative accuracy of JPMCs spot rate forecasts?
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Chapter 10
Additional Chapter Exhibits
Exhibit 10.2 The Economies and Currencies of Asia, JulyNovember 1997
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Exhibit 10.4 Argentinas Economic Performance, 19912000
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Exhibit 10.5 Argentinas Debt and Key Balances, 19912000
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Exhibit 10.7 Exchange Rate Forecasting in Practice
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Exhibit 1 Monthly Average Exchange Rates: US$/
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Exhibit 2 Monthly Average Exchange Rates: Japanese Yen per U.S. Dollar
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Exchange Rate Determination

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Chapter 10

Foreign Exchange Rate Determination and Forecasting

Copyright 2010 Pearson Prentice Hall. All rights reserved.

Foreign Exchange Rate Determination

Copyright 2010 Pearson Prentice Hall. All rights reserved.

Foreign Exchange Rate Determination

Copyright 2010 Pearson Prentice Hall. All rights reserved.

Exhibit 10.1 The Determinants of Foreign Exchange Rates

Copyright 2010 Pearson Prentice Hall. All rights reserved.