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Chapter 5
Foreign Exchange Rate Determination
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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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Parity Conditions1. Relative inflation rates2. Relative interest rates3. Forward exchange rates4. Interest rate parity
Balance of Payments1. Current account balances2. Portfolio investment3. Foreign direct investment4. Exchange rate regimes5. Official monetary reserves
Asset Approach1. Relative real interest rates2. Prospects for economic growth3. Supply & demand for assets4. Outlook for political stability5. Speculation & liquidity6. Political risks & controls
SpotExchange
Rate
Is there a well-developedand liquid money and capitalmarket in that currency?
Is there a sound and securebanking system in-place to supportcurrency trading activities?
Exhibit 5.1 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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Exchange Rate Determination: The Theoretical Thread
• 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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Exchange Rate Determination: The Theoretical Thread
• 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 country’s 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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Illustrative Case: The Asian Crisis
• 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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Illustrative Case: The Asian Crisis
• 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 5.3 Comparative Daily Exchange Rates: Relative to the US$
INSERT EXHIBIT 5.3
Apr97
Sep97
Jan98
Mar98
May98
Jul98
Jun97
Aug97
Nov97
May97
Oct97
Jul97
Dec97
Feb98
Apr98
Jun98
Aug98
Sep98
120
110
100
90
80
70
60
50
40
30
20
10
Philippine PesoThai BahtMalaysian RinggitIndonesian Rupiah
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Illustrative Case: The Russian Crisis of 1998
• The crisis of August 1998 was the culmination of a continuing deterioration in general economic conditions in Russia.
• From 1995 to 1998, Russian borrowers (both government and non-governmental) had gone to the international capital markets for large quantities of capital.
• Servicing this debt soon became an increasing problem, as it was dollar denominated and required dollar denominated debt service.
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Illustrative Case: The Russian Crisis of 1998
• The Russian current account (while a healthy surplus of $15 - $20 billion per year) was not finding its way into internal investment and external debt service.
• Capital flight began to accelerate, and hard currency earnings flowed out of the country.
• As the Russian rouble operated under a managed float, the Central Bank had to intervene in foreign exchange markets to support the currency if it came under pressure.
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Illustrative Case: The Russian Crisis of 1998
• During the month of August, 1998, the Russian government continued to drain its reserves and had increasing difficulties in raising additional capital in support of its reserves on the international markets.
• By mid-August, the Russian Central Bank announced it would allow the rouble to fall, postponed short-term domestic debt service and initiated a moratorium on all repayment of foreign debt owed by Russian banks and private borrowers to avert a banking collapse.
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Exhibit 5.4 Daily Exchange Rates: Russian Rubles per US$
Jun98
Nov98
Mar99
May99
Aug98
Oct98
Jan99
Jul98
Dec98
Sep98
Feb99
Apr99
27.5
25.0
22.5
20.0
17.5
15.0
12.5
10.0
7.5
5.0
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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 nation’s standard of living in the past.
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Illustrative Case: The Argentine Crisis of 2002
• 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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Illustrative Case: The Argentine Crisis of 2002
• 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 5.7 The Collapse of the Argentine Peso
02023162 889 722 16 30 3132
3.75
3.50
3.25
3.00
2.75
2.50
2.25
2.00
1.75
1.50
1.25
1.00
0.75
Jan 2002 Feb 2002 Mar 2002
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Forecasting in Practice
• Numerous foreign exchange forecasting services exist, many of which are provided by banks and independent consultants.
• Some multinational firms have their own in-house forecasting capabilities.
• Predictions can be based on elaborate econometric models, technical analysis of charts and trends, intuition, and a certain measure of gall.
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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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Foreign currency perunit of domestic currency
FundamentalEquilibrium
Path
Technical or random events may drive the exchange
rate from the long-term path
Exhibit 5.10 Differentiating Short-Term Noise from Long-Term Trends
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Exhibit 5.11 Exchange Rate Dynamics: Overshooting
S0
t1 t2
S1
S2
Spot ExchangeRate, $/
Overshooting
Time
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Mini-Case Questions: JP Morgan Chase’s 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 JPMC’s spot rate forecasts?