Foreign Exchange Rate Determination and Forecasting

Chapter 9

Foreign Exchange Rate DeterminationExchange rate determination is complex.Exhibit 9.1 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.

Exhibit 9.1 The Determinants of Foreign Exchange Rates0

Foreign Exchange Rate DeterminationWithout 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 that affect the exchange rate markets.

Exchange Rate Determination: The Theoretical ThreadThe 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.0

Exchange Rate Determination: The Theoretical ThreadThe 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.0

Exchange Rate Determination: The Theoretical ThreadThe 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 when currency flows match up vis--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.0

Exchange Rate Determination: The Theoretical ThreadThe 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.0

Exchange Rate Determination: The Theoretical ThreadThe 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.0

Exchange Rate Determination: The Theoretical ThreadThe 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.0

The Asset Market Approach to ForecastingThe 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 ratesProspects for economic growthCapital market liquidityA countrys economic and social infrastructurePolitical safetyCorporate governance practicesContagion (spread of a crisis within a region)Speculation0

The Asset Market Approach to ForecastingForeign 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).0

Currency Market Intervention (Why?)Foreign currency intervention is the active management, manipulation, or intervention in the markets valuation of a countrys currency.Why Intervene?Fight inflation (strong currency)Fight slow economic growth (weak currency)

Currency Market Intervention (How?)Methods of intervention are determined by magnitude of a countrys economy, magnitude of trading in its currency, and the countrys financial market developmentDirect Interventionthe active buying and selling of the domestic currency against foreign currenciesIf the goal is to increase the value, then the central bank buys its own currencyIf the goal is to decrease the value, then the central bank sells its own currency

Currency Market Intervention (How?)If bank intervention is insufficient, then coordinated intervention may be used whereby several central banks agree on a strategy to increase or decrease a currency value.Indirect Intervention is the alteration of economic or financial fundamentals which are thought to be drivers of capital to flow in and out of specific currencies.Increase real rates to strengthen a currencyDecrease real rates to weaken a currency

Currency Market Intervention (How?)Capital Controls are restrictions of access to foreign currency by the government by limiting the exchange of domestic currency for foreign currency.

Disequilibrium: Exchange Rates in Emerging MarketsAlthough 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.0

Illustrative Case: The Asian CrisisThe 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.0

Illustrative Case: The Asian CrisisThe 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 (see Exhibit 9.2) and soon other Asian currencies (Philippine peso, Malaysian ringgit and the Indonesian rupiah) came under speculative attack.0

Exhibit 9.2 The Thai Baht and the Asian Crisis

Illustrative Case: The Asian CrisisThe Asian economic crisis (which was much more than just a currency collapse) had many roots besides traditional balance of payments difficulties:Corporate socialismCorporate governanceBanking liquidity and managementWhat started as a currency crisis became a region-wide recession.0

Illustrative Case: The Russian Crisis of 1998Debt service had become a real problemCapital flight was taking placeThe ruble traded via a managed float that had been continually adjusted since 1996August 7, 1998 began the August Crash with the announcement that currency reserves had fallen $800M in the last weekAugust 10, the Russian stock market falls 5%August 17, Russia announces the ruble will be allowed to devalue by 34%Exhibit 9.3 illustrates the rubles decline

Exhibit 9.3 The Fall of the Russian Ruble

Illustrative Case: The Argentine Crisis of 2002In 1991 the Argentine peso had been fixed to the U.S. dollar at a one-to-one rate of exchange.A currency board structure was implemented in an effort to eliminate the source inflation that had devastated the nations standard of living in the past.0

Illustrative Case: The Argentine Crisis of 2002By 2001, after three years of recession, three important problems with the Argentine economy became apparent:The Argentine peso was overvaluedThe currency board regime had eliminated monetary policy alternatives for macroeconomic policyThe Argentine government budget deficit and deficit spending was out of control0

Illustrative Case: The Argentine Crisis of 2002In 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.Exhibit 9.4 tracks the decline of the Argentine peso

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Exhibit 9.4 The Collapse of the Argentine Peso

Forecasting in PracticeTechnical 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-dayShort-term (several days to several months)Long-term0

Forecasting in PracticeThe 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.Exhibit 9.5 summarizes the various forecasting periods, regimes, and the authors suggested methodologies.

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Exhibit 9.5 Exchange Rate Forecasting in Practice

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 termThere is, therefore, something of a fundamental equilibrium path for a currencys value.0

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.Exhibit 9.6 illustrates the synthesis of forecasting thought.Exhibit 9.7 shows the dynamics of exchange rate manipulation.

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Exhibit 9.6 Short-Term Noise Versus Long-Term Trends

Exhibit 9.7 Exchange Rate Dynamics: Overshooting