Economics for Valuation Currency Exchange Rates: Determination and Forecasting (Part 2) International Fisher Relation (IFR) Relative PPP = Relative PPP: Changes in exchange rates will just offset changes in price levels (ie., differences in inflation) = Beante: E(%A8)(a)= Ete) — Een) = Countries with higher (relative) inflation expect to see their currencies depreciate (by the inflation differential). Uncovered Interest Rate Parity = Domestic Fisher Relation: Rers+E(x) R = nominal interest rate, r = real interest rate, = International Fisher Relation: Assuming real rates are constant (real rate parity): Ry — Re = Eley) ~ Elsa) {ie., interest rate differential = inflation differential) = Relative form PPP + intemational Fisher relation = uncovered interest rate parity 1» Links spot exchange rates, expected spot exchange rates, and nominal interest rates E(%A8) ye)= Ra PoSimilarity = Covered and uncovered IRP are related = Why? Because F = E(S,) if forward rate is an unbiased estimator of future spot rate = Uncovered IRP: Forecast future spot = E(S,) = Remember, this is a non-traded price = Covered IRP: Calculate the forward rate = F «= All the elements are tradable (S, F, tg fe) = Covered IRP is bound by arbitrage International Parity Relations Foard rate Exchange rele “ihbiased pred of ~~ >) @™pectations! pare future spo rates ion Covoredintorest _—_Uncoveredinterest ‘Relative purchasing parity rate parily power parity Tefaion rato sitforarial Carry Trade = If uncovered interest rate parity does not work in the short term, one can profit by investing in higher yielding currency and borrowing in lower yielding currency. = Assume that USD interest rate = 3% while GBP interest rate = 2% and USD is expected to depreciate by 0.5%. ‘= Return = interest eamed on investment — funding cost ~ currency depreciation = 3% — 2% — 0.5% = 0.5%. ks of Carry Trade = Crash risk due to non-normal distribution of carry trade returns «= In times of high volatiliy, the country with the higher interest rate typically sees its currency depreciate by a greater amount than uncovered IRP suggests = Negative skewness and excess kurtosis = Risk management «= Volatility fiter using options markets «Valuation filter using PPP bandsLong-Run Fair Value ‘= IMF framework for assessment of long-run fair value of a currency 4, Macroeconomic balance approach — clues from current account deficits 2. External sustainability approach — clues from external debt relative to GDP 3, Reduced form econometric approach - estimation of ‘equilibrium exchange rate path consistent with several key macroeconomic variables Balance of Payments Accounts = Current account influences: 1. Flow mechanism Lay i at eventual 2. Ponttlio composition mechanism? | caise eumency 3. Debt sustainability mechanism to depreciate Flow mechanism: = Size of initial defi * Influence of XA rates on domestic imports and export prices: + Price elasticity of demand » Balance of Payments Accounts ‘= Capital (financial) account: « In the short term, real currency values fluctuate around its long-term PPP-implied equilibrium value. «= The real value is positively related to real interest rate differential and negatively related to risk premium differential Taylor Rule = Central Bank policy rate determination Ra,+a+a(q7—2")+b(y-y") R= central bank policy rate implied by Taylor rule : rate (and hence t= neutral real policy interest rate currency value) fs z and x” = current and target inflation rate | positively related to y and y* = log of current and target output [inflation and output. a. B = policy response coefficients The real interestMundell-Fleming Model + Impacts of inflation not modeled (focuses on interest rate) Monetary policy/Fiscal policy Capital Mobility High Low Expansionary/Expansionary Uncertain Depreciation Expansionary/Restricive Depreciation Uncertain Restrctive/Expansionary Appreciation Uncertain Restictive/Restrctive Uncertain Appreciation Monetary Approach Focuses on Inflation Impacts = Pure monetary approach: PPP holds at any point in time. Expansionary (restrictive) monetary policies lead to higher (lower) inflation and depreciation (appreciation) of currency. = Dornbusch overshooting model: Prices may not reflect, Policy changes in syne (sticky output prices), This leads to ‘overreaction to policy changes. Expansionary (restrictive) monetary policies lead to higher (lower) inflation and depreciation (appreciation) of currency. Portfolio Balance (Asset Market) Approach ‘= Mundell-Fleming model looks at short-term implications of fiscal policy. = Portfolio balance approach looks at long-term impli of fiscal policy. In the long term, governments may find it increasingly dificult to fund sustained deficits, leading to depreciation of the currency. 1s Objectives of Central Bank Intervention = Ensure that the domestic currency does not appreciate excessively = Allow the pursuit of independent monetary policies = Reduce excessive inflow of capitalEffectiveness of Central Bank Intervention = Central bank can intervene in FX markets or policy makers can employ capital controls. ‘= Effectiveness of intervention in FX markets depends on the size of central bank reserves relative to trading volume of their currency. Usually not effective for developed countries. = Effectiveness of capital controls depends on the size and persistence of capital flows. Warning Signs of Currency Crisis * Terms of trade deteriorate + Dramatic decline in official foreign exchange reserves + Real exchange rate substantially higher than mean reverting level * Inflation increases + Equity markets experience boom-bust cycle + Money supply relative to bank reserves increases + Nominal private credit grows Technical Analys * Trend following trading rules ~ have not worked post 1995 for developed market currencies. = FX-order books ~ strong contemporaneous correlation but no predictive ability * Currency options market - volatility implied by call prices relative to volatility implied by put prices. Positive contemporaneous correlation but no predictive ability. Keys to the Exam Foreign Exchange ‘Mark-to-market value of forward contract Cross rates and triangular arbitrage = Parity conditions = BOP analysis = Monetary/fiscal policies and exchange rates = Currency crisis