BITS Pilani

K KBirla Goa campus

ECON F 312 : Forex rate determination

Anoop S Kumar

Topics

How BOP explains exchange rates?

Asset market approach to exchange rates.
Forecasting in practice.
How different theories combine to explain recent currency crises?

BITS Pilani, K K Birla Goa Campus

Exchange Rate Determination

Basic approaches
Parity conditions
Flow (BOP) approach
Stock (asset market) approach

In addition, need to account for important social &

economic events, such as:

Infrastructure weaknesses,
Speculation,
Cross-border FDI,
Foreign political risks.

BITS Pilani, K K Birla Goa Campus

Flow (BOP) Approach

Current
Account
Balance

Capital
Account
Balance

(X-M)

(CI-CO)

Financial
Account
Balance
+

Reserve
Balance
=

(FI-FO)

Balance
of
Payments

FXB

BOP

X exports, M imports
CI capital inflows, CO capital outflows
FI financial inflows, FO financial outflows
FXB official monetary reserves

Forex as a medium of exchange.

BITS Pilani, K K Birla Goa Campus

BOP Approach
Fixed Exchange Rate Countries
Government bears responsibility to ensure BOP near 0.

-If government lacks reserves, will have to devalue.

Managed Float Countries
To defend currency, may raise interest rates.
=> raises cost of capital for domestic firms

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Stock (Asset Market) Approach

Forex as a store of value
Willingness to hold monetary claims depends on relative
real interest rates & on countrys economic growth &
profitability.
Asset approach is forward looking: discounted future value

St

/$

1 i$
1 i$
/$
/$

Ft ,1
E St 1
1 i
1 i

Movements in exchange rate reflect news.

Current exchange rate is set to equilibrate risk-adjusted
expected return on assets denominated in different
currencies.
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Asset Model Approach

Monetary Approach
perfect capital substitutability
Risk premium = 0
Interest rate parity

Monetarist Model
completely flexible
commodity prices

Overshooting Model

Portfolio-Balance Approach
imperfect capital substitutability
Note: risk premium =/= 0
Forward rate biased predictor

Preferred Local
Habitat Model
Uniform Preference
Model

sticky commodity prices

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Asset Model: Monetary Approach

Spot exchange rate is relative price of two monies.
Flexible price model: Domestic good prices fully flexible
If domestic money supply increases domestic currency will depreciate.
If domestic real income Y rises/ domestic interest rate i falls, domestic currency
will appreciate as money demand is increased

Stick price model: Goods prices are sticky (slow to adjust)

relative to asset prices.
Asset prices have to move by more than in flexible price case, in order for
markets to reach equilibrium.

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Asset Model: Portfolio-Balance

Portfolio-balance model has two financial assets (money &
bonds) and two countries (home & foreign).
Exchange rate establishes equilibrium in investor portfolios
of domestic money & domestic and foreign bonds.
Balance between domestic and foreign bonds in a portfolio
is positively related to expected excess return on
domestic bonds over foreign bonds.
Investors asset preferences may be similar across
countries (uniform preference model), or investors may
prefer assets of their home country (preferred local
habitat model).
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The Portfolio-Balance Approach

Effects of Macroeconomic Shocks on forex
Model

all

preferred
local
habitat

Increase in:

Impact on
home currency

supply of home country bonds

supply of foreign country bonds
domestic interest rates
foreign interest rate
expected rate of home currency
depreciation

+ depreciates
- appreciates
- appreciates
+ depreciates
+ depreciates

home wealth
home country current account
surplus

- appreciates
- appreciates
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Forecasting Techniques
3 general types of forecasts:
1. Intuitive expectations should be sufficient efficient
market approach
2. Monetary policy fundamental approach.
3. History technical approach.

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Efficient Market Approach

Markets are efficient & reflect all available information.
Markets will follow random walk by changing only when
unpredicted events occur (i.e. news). St = E[St+1].
PPP can be interpreted as markets consensus forecast of
future exchange rates if markets efficient Ft,1 = E[St+1| It].

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Fundamental Approach
Exceedingly technical. Widely used in banks.
Heavy econometrics 3-step process:
1.
2.
3.

Estimate structural model.

Estimate future parameter values.
Use the model to develop forecasts.

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Technical Approach
History repeats itself.
Data mining in search of patterns.
Largely reliant on short-term & long-term moving averages
and divining patterns in the graphs.
Not well-regarded in academia, but extremely popular
among traders

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Example of Technical Analysis

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Source: http://www.investavenue.com/article.html?ID=5761

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Forecasting in Practice
Short-term forecasts: hedge receivable, payable, or
dividend
Long-term forecasts: capital structure, entry mode of
investment
Cross-rate consistency.
E.g. HQ forecasts Yen 120/$, $1.50/Pound
Regional managers forecast Yen 150/Pound.
=> Inconsistency.

Stabilizing expectations.

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Anatomy of a crisis -- Asia97

What caused it? Supply driven: net exporters became net
importers.
Thai banks had access to capital & US$ debt at low rates.
1997: Thai Baht under attack due to countrys rising debt.
Thai government intervened directly selling reserves &
indirectly raising interest rates.
Massive currency losses and bank failures led to July 1997,
central bank allowed Baht to float.
Contagion: Taiwan devaluation (15%), Korea (18.2%),
Malaysia (28.6%), Philippines (20.6%) against the $.
Not affected: Hong Kong $ and Chinese renminbi.
Countries had similar characteristics: corporate socialism,
in-transparent corporate governance, banking liquidity
and management.

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Asian Crisis

Thailands Deteriorating Balance of Payments, 1991-1998

Excess capital inflows, 1996 & 1997

25
20

10

19
98

19
97

19
96

19
95

19
94

19
93

-5

19
92

19
91

Billions of US dollars

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-10

-15
-20

Current Account

Source: International Financial Statistics, IMF

Capital/Financial Account

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Russian Crisis
During 1995-1998, Russian borrowers (public & private)
tapped international markets for capital.
Servicing debt a problem as US$ were required for
payments
Russian rouble operated under managed float w/in band of
RU 5.75/$ to RU 6.35/$
Even after $4.3bn IMF facility, rouble fell under attack
August 1998
Financing options dried up, debt issuance cancelled.
Russia began printing money for domestic payments.
Russia defaulted on foreign debt, first time Eurobond
default.
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Postponed $43bn short-term debt & 90-day moratorium
onGoa Campus
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Brazilian Crisis 1/ 1999

(read on own)

Continuing CA deficits and domestic inflation puts in 1998

pressure on real
Heavy outflow of capital, stock market down.
Central bank raised short-term interest rates 36% -> 41%
April 1999, real appreciated against the dollar.

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Things to remember
BOP and asset market approaches to exchange rates.
Forecasting in practice.
How different theories combine to explain recent currency crises Asia, Russia?

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