theories of foreign exchange determination

8/6/2019 Theories of Foreign Exchange Determination

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Exchange Rate

Determination

Dr. C S Shylajan


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Introduction

An exchange rate is the relative price of onecurrency in terms of another

It influences allocation of resources within andacross countries

During the Bretton Woods era exchange rate wastreated as an exogenous variable

With the advent of floating rates in 1973, attention

once again shifted to determinants of exchangerates themselves


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Introduction

Exchange rates are affected by many factors.

For instance, Balance of payments, inflation,interest rates, money supply, political factors,

market sentiments, technical factors etc.

Important ones are Price and Interest rates

What is the relationship of these two variables withexchange rates?


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Some Fundamental Relationships T

here are two popular forms of Purchasing PowerParity theory.

Absolute form of PPP

& Relative form of PPP

Absolute form of PPP: Without internationalbarriers, consumers shift their demand to whereverprices are lower.

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Some Fundamental Relationships

Absolute Purchasing Power Parity (PPP)

The price levels in different countries determine theexchange rates of these countries currencies.

Exchange rates reflects the purchasing power of these

currencies.Rs.2000 for a basket of goods in India. Same basket costs $50 inUS. Then exchange rate between the Rupee and the dollar is2000/50 =Rs40/$

PURCHASING POWER PARITY : A DOLLAR IS WORTH 40 RUPEES

BECAUSE WHAT COSTS $1 IN US COSTS Rs.40 IN INDIA

Lawofone price: Price of a specified bundle of goodsand services, denominated in a given currency is sameeverywhere

St= Ph / P*f


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Stis the spot rate expressed as number of units ofhome currency per unit of foreign currency

Ptis the price index in the home country and Pt*is theprice index in the foreign country, both price indices withreference to a common base year


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Based on some assumptions Free movement of goods

No transportation cost

No transaction cost

No tariff or quota


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.IS IT EMPIRICALLY VALID?

THE ANSWER IS NO (why).

This "law"is not valid in practice because of transport costs,tariffs, quality differences etc.

Empirical testing also difficult. (composition of index is different,base year different)



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PURCHASING POWER PARITY

IN THIS FORM, IT MAY BE VALID OVER THE LONG RUN -

PERIODS OF 10-15 YEARS OR LONGER. NOT OF MUCHUSE IN FORECASTING EXCHANGE RATES FOR SHORTTERM PURPOSE

WITH DIFFERENCES IN PRODUCTIVITY GROWTH RATES,IT MAY NOT BE VALID EVEN IN THE WEAK FORM.


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PPP

PPP states that the exchange rate betweencurrencies of two countries is equal to the ratiobetween the prices of the two countries

In relative terms, PPP states that the exchangerate between the currencies of the two countrieswill adjust the changes in the inflation rate of thetwo countries.


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Relative Purchasing Power Parity

Percent change in exchange rate equals inflationdifferential% Change in Rupee/Dollar Exchange Rate

= Inflation Rate in India Inflation Rate in US

This will be true if St = k(Pt/P*t) k: Some constant

Faster inflation at home Home currencydepreciates at a rate equal to its excess inflation rate.IF DURING A YEAR INFLATION IN US IS 5% WHILE INFLATION IN JAPAN IS 3%,

DOLLAR WILL DEPRECIATE AGAINSTTHE YEN BY 2%. CHANGE IN EXCHANGE

RATEEQUALS INFLATION DIFFEENTIAL.



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According to relative form of PPP principle, thepercentage change in the spot exchange rateequals the difference in the inflation rates dividedby 1 plus the inflation rate in country B

Example: If the inflation rate in India (country A) is 10% and

that in the US (country B) it is 3%, the Rs/$ ratewould change over a period of one year by

(0.10-0.03)/(1+.03) =0.068 =6.8%

Indian rupee will depreciate by 6.8%


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Real Exchange Rate is a measure ofexchange rate between two currencies adjustedfor relative purchasing power of the currencies

Re = Ste (Pd/Pf)

Ste denotes the nominal exchange rate at time twhile Pt

d and Ptfare price indices (say CPIs) in

countries A and B with reference to a common

base year. The real exchange rate Rt is alsoexpressed as an index with reference to thesame base year


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Interest Rate Parity (IRP)

H

ow is it possible to determine the rate ofexchange under a forward contract?

A forward exchange rate is the rate that is currentlypaid for the delivery of a currency at some future

date. It has the spot rate as its base, plus the interest

factor.

The interest factor which is factored into the rate iscalled the interest rate parity


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Interest Rate Parity

It states that the exchange rate between currenciesof two countries will be affected by their interestrate differential.

interest rate differential = exchange rate differential


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OTHER BASIC RELATIONSHIPS

COVERED INTEREST PARITY:

AMONG CONVERTIBLE CURRENCIES SPOT-FORWARDMARGIN EQUALS INTEREST RATE DIFFERENTIAL

INTEREST RATE DIFFERENTIAL EQUALS EXPECTEDCHANGE IN EXCHANGE RATE.

UIP NOT

FOUNDE

MPIRICALLY VALID (WH

Y?)


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If Relative PPP holds, RealE

xchange rate would remainconstant

The nominal and real exchange rates we have consideredare bilateral rates

The concept ofEffective Exchange Rate (EER) is utilizedto make multilateral comparisons

Nominal EER (NEER) captures movements in a currencyvis--vis a basket of currencies.

Real Effective Exchange Rate (REER) attempts to

capture changes in competitiveness vis-a-vis a group ofcompetitors in world markets rather than pair-wisecomparisons. It is NEER adjusted for inflation differencesbetween home and basket currency countries


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Purchasing Power Parity (PPP) as a Model ofExchange Rate Behaviour and Predictor

Absolute PPP does not hold in practice. Reasons aretransport costs, non-homogeneous goods, non-traded

goods, trade barriers, non-homogeneous tastes etc. Relative PPP is found to hold approximately over long

periods of time several years.

Not very useful for short-term prediction of exchange

rates Can provide an indication of long term trends if

inflation trends can be reasonably assessed.


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Fis

her Eff

ect Relationship between interest rate, inflation rate and

exchange rate

According to Fisher,

i = r + where i = nominal interest rate; r = real interest rate; and = inflation

rate

If money were free from all controls when transferred

internationally, the real rate of interest should be thesame in all countries (otherwise it will create anarbitrage opportunity)

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Combine UIP with relative PPP Let e denote the expected proportionate change in

the exchange rate

Take UIP

iA iB = e = TeA -TeB

iA -TeA = rA

iB -TeB = rB

This implies that with free capital flows and risk neutral

investors real interest rates are equalized between

A and B

-=Se

BA

ee


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Principle that a difference in nominal interest ratessupported by two countries currencies will cause anequal but opposite change in their spot exchange rates

Real interest rates are theoretically equal across

countries Any difference in interest ratesin two countriesmust be due to different expected ratesofinflation

A country that is experiencing inflation higher than

that ofanother country should see the value ofitscurrency fall

The exchange rate must be adjusted to reflect thischange in value.

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Reasonsfor Departure from Interest Rate Parity

Capital Controls:

restrictions on investing or borrowing abroad

restrictions on repatriation of investments made by

foreigners restrictions on conversion of currencies

Transaction Costs:

the bid-ask spread, the cost involved in conversion of

currencies; deposit lending spread, the difference between the

deposit and lending rates in the money market

Political Risks,Taxes, etc22


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Exchange Rate Forecasting

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Introduction

Many theories on the exchange rate determination Exchange rates (floating), like any price, is determined

by the forces of supply and demand

The problem is to correctly model all the factors that

influence the demand for and the supply of a currency Another complication is that foreign exchange is an

asset like equity shares

Like any such assets, its price at any time is heavilyinfluenced by expectations about future course of price

These expectations are very sensitive to economicevents, political developments, technologicaldevelopments, resource discoveries, etc.


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Several factors affect the movements in exchangerates, often in a conflicting manner

Exchange rate theories can be used for exchangerate forecasting

But prediction of the exact level of future exchangerates is not possible

But forecasting of exchange rate is vital for important

players in the international markets and also for thespeculators.

Effectiveness of a forecasting tool accuracy andunbiasedness


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Forward Rate as a Predictor

Forward rate, an unbiased predictor of futurespot rate provided,

Market should be competitive, the currencies

should be freely floating However, no evidence that the forward rates

as accurate predictors of future rates

Reason: future spot rates are affected by allthe expected and unexpected developments

The unexpected factors cannot be factored inthe forward rates


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Demand Supply Approach

Exchange rates can be forecasted by analyzing thefactors that affect the demand and supply of a currency

These factors are listed out in the BoP account.Therefore, this approach also known as balance-of-

payments approach

Exchange rate is the equilibrium price that equatesthese demands and supplies

Different models of exchange rates differ in theemphasis they put on the different components ofdemand for and supply of a currency


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Demand for currency A arisesfrom:

1. Rest of the World (ROW) purchasing goods andservices from country A and making payments in Ascurrency (including payments for factor services) ormaking unilateral transfers to residents of A

2. ROW wishing to hold financial assets denominated incurrency A; ROW wishing to make direct investments in A

Supply ofcurrency A arisesfrom:

1. Residents of country A wishing to buy goods andservices from ROW or make unilateral transfers to ROW

2. Residents of country A wishing to make direct andportfolio investments abroad including central bank of A


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Simplest view of exchange rate focuses on demand forand supply of foreign exchange arising out of importsand exports (known as Flow Models)

According to Flow Models, as the home currency

depreciates, imports become more expensive whileexports become cheaper in terms of foreign currency

Demand for imports falls while for exports expands

Supply of foreign currency rises while demand shrinks,

putting upward pressure on the home currency


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Suppose, demand for imports rises (due to fastereconomic growth at home, etc), other thingsremaining the same, the home currency willdepreciate

Alternatively, exports shrink (due to supplyproblems in export industries, economic slow downin buyer country, competition, etc), home currencydepreciate

Conversely, when demand for imports shrinks orthat for exports rises, the home currencyappreciate


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Thus, in this approach the exchange rate isinfluenced by the forces affecting demand andsupply of imports and exports

These include fiscal and monetary policies thataffect the level of economic activity, productivitychanges, changes in consumer preferences, tariffsand trade barriers, etc


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D S E: Equilibrium Exchange

Rate

Exchange

Rate

Rupee/$

E

S

D

No. of Dollars

Figure 1


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This theory says, any change in the value of currencyis only an instrument to correct the temporary

imbalance in the systemAt the same time, imported goods are more expensive

due to depreciation, reducing imports

This improves the current account balance

But despite a depreciation, the current accountbalance may worsen. Why?

J-curve effect

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Some times, while thephysical volume of our exportsmay increase, but the amount of foreign currencyearned from those exports may decrease.

This happens due to low price elasticity of demand for

exports. When both imports and exports are price inelastic inthe short run but price elastic in the long run, volume ofexports and imports do not immediately respond to thechange in relative prices of exports and imports,

caused by depreciation of currency. This leads todeterioration in the Balance of Trade. Then currencydepreciates further.-J Curve

People take some time to adjust to the changes in

relative prices (time lag)34


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Major problem with the model is its total neglect ofcapital account

Mundell-Fleming model attempts to correct this byincluding capital flows.

Capital flows dependent on interest rate differentialbetween home and the ROW

Current account balance depends upon the NationalIncome and exchange rate;

Capital account balance depends upon the interestrate differential

National income and interest rates are influenced bythe fiscal and monetary policy.


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Asset Market Models

The Monetary ModelAccording to this approach, exchange rates are

essentially monetary phenomena.

Assumptions:

There is only one asset viz. money. Residents ofa country hold only that countrys money.

Purchasing Power Parity holds (an increase in

countrys price level results in the depreciation ofthat countrys currency and vice versa)

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The Monetary Model

The core of the model is the assertion thatdomestic residents, when faced with a discrepancybetween the stock of (domestic) money they wishto hold and the actual stock of money created by

the monetary authority, will attempt to correct it byrunning a balance of payments deficit or surplus

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The Monetary Model Suppose, real GNP of a country increases, resulting in an

increase in the real money demand With no change in money supply, lesser money is left for

purchase of goods, services that brings down the pricelevel

A reduction in price level causes appreciation of thecurrency

Thus, increase in real GNP brings an appreciation of thecurrency

Suppose, there is excess supply of money, resulting inincreased demand for domestic as well as foreign goods

The domestic price level rises and the exchange ratedepreciates

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The Monetary Model

Thus, the monetary approach predicts that strongeconomic growth coupled with moderate growth inmoney supply and credit will result in a strong and

stable currency, while excessive credit creation,especially when the economy is not growingrapidly, will cause a fall in currency

Is it true with Rupee appreciation and depreciationepisodes?

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The Monetary Model

This model also predicts that an increase in homecountry interest rate, given other things, will lead to adepreciation of a home currency

Why?

This go against the common notion (that higherinterest rate leads to higher capital inflows)

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i i i


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Expectations, News.Technical analysis

etc

Expectations,

the Efficient Markets Hypothesis and

the Role of "News" EMH does not talk about the effect of changes in

the basic economic variables.

Current exchange rate is the reflection of the

expectations of the market as a whole.


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Structural Models of Exchange Rate

Any new pertinent information alters traders' viewsregarding future course of prices and is immediatelyreflected in the current price

Importance of expectations and unanticipated events

Technical Analysis

Economic variables are ignored.

Using historical data


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Summary-Exchange Rate Forecasting

Exchange rate forecasts are an important input into a

number of corporate financial decisions Forecasting methodologies can be divided into two

broad categories Structural economic models of exchange rate

determination such as the PPP or the monetaristmodel Pure forecasting models" that includes time series

methods and "technical analysis"

Recent developments in modeling and predictingfinancial time series have applied mathematicaltools.

Composite Forecasts A combination of differentforecasts


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The

value

ofafo

recast depend

sup

on

How much does the forecast contribute to betterdecision making given that the firm has its ownsources of information and is able to generate its

own forecasts The forward rate is always available as a forecast

free of charge. Any forecast paid for must doconsiderably better than forward rate in predicting

direction and magnitude of movement


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The Exchange Rate of the Rupee

Central Bank has still an important role

RBI acts to moderate excessive fluctuations andprevent panics.

Behavior of the spot rate in India is largely governed bytrade related flows since the capital account continuesto be strictly controlled

In the very short run, portfolio decisions of FIIs cangenerate significant volatility in the rupee exchangerate as we have seen recently.


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Thanks

theories of foreign exchange determination

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