Transcript International Finance I

The Determination
of Exchange Rates
1
Overview of the lecture
1. Presentation of the Problem
2. The Balance of Payments Approach
3. The Economic Approaches
4. The Asset Pricing Approaches
5. Forecasting
© 2002 by Stefano Mazzotta
1. Presentation of the
Problem
3
A very difficult task
• Many theories of exchange rates determination
exist. None of them is preeminent. All of them
are used.
• Many people are involved in trying to determine
exchange rates: Academics in economics and in
finance, political men, central bankers, bankers,
international financial institutions, practitioners...
Within each profession, people do not agree.
• Example: the current value of the CAD
© 2002 by Stefano Mazzotta
What should be the value of
the CAD? (July 2002)
• An global investment bank’s monthly report.
• Another global investment bank’s short-term
view
• An internationally renowned research analyst
group’s forecast.
• The prime minister and the finance minister of
Canada’s opinions.
• A currency options trader’s comment.
© 2002 by Stefano Mazzotta
4
5
Potential FX determinants
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Different dual approaches
• Short-term/Long-term
• Monetarist/Keynesian
• Economics/Finance
• Fundamentals/Technical analysis
© 2002 by Stefano Mazzotta
2. The Balance of Payments
Approach
8
Assumptions
• The flow supply of, and demand for,
currencies determine the equilibrium
exchange rate.
• Original model focused only on the role of
trade flows.
• More general models include also the role of
capital flows.
• Data needed: the flows of the balance of
payments and the elasticities of trade flows in
response to a movement in exchange rate.
© 2002 by Stefano Mazzotta
The usual “Demand and
Supply” picture
e(JPY/CAD)
S’
S
e1
e0
D’
D
Q0
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Q(CAD)
9
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Interpretation
• An increase in inflation in Japan for example
would lead Japanese and Canadian people to
consume more Canadian goods and services
relative to Japanese ones:
– Japanese will demand more CAD
– Canadians will supply less CAD
• Other scenarios include changes in interests
rates, economic growth, political uncertainty...
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11
BOP of the big five
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BOP and U.S. dollar
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Bloomberg Article
• U.S. Trade Gap Widened to a Record $40.1 Billion in
November
By Carlos Torres
• Washington, Jan. 17 (Bloomberg) -- The U.S. trade deficit
widened to a record $40.1 billion in November as imports
surged following a resumption of business at West Coast ports,
a government report showed.
• The wider trade gap in goods and services followed a revised
$35.2 billion shortfall in October and reflected a record inflow of
holiday and other consumer merchandise, the Commerce
Department said. Imports had declined in October, when ports in
California, Oregon and Washington closed early in the month
after shippers locked out union dockworkers in a labor dispute.
…..
© 2002 by Stefano Mazzotta
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• Faster growth in the U.S. compared with its
trading partners will probably keep imports
growing faster than exports and widen the
trade gap in coming months, economists
said.
• The U.S. economy is expected to grow 2.8
percent this year while Japan, the world's
second-biggest economy, is seen expanding
0.9 percent, according to consensus
estimates of economists polled by Blue Chip
Economic Indicators. The economy of the 12
nations that share the euro as their common
currency is projected to grow 1.7 percent.
© 2002 by Stefano Mazzotta
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• A drop in the value of the dollar last year may
help stimulate exports by making Americanmade goods less expensive relative to foreign
products, some economists say. The dollar is
down 5 percent from its peak in January 2002
against a trade- weighted basket of
currencies from 37 of the country's largest
trading partners.
• ``Eventually you would expect some relief to
our exports from the lower dollar, but I don't
expect it until the end of the year,'' said Lara
Rhame, an economist at Brown Brothers
Harriman & Co. in New York, before the
report.
© 2002 by Stefano Mazzotta
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Conclusions
• Difficult to justify the big swings in the
observed exchange rates by the BOP
• The driving forces behind the changes in the
BOP cannot be easily identified by looking
only at the BOP (e.g. which one came first,
current account deficit or capital account
surplus?)
• The “pure” foreign exchange market forces
are not taken into account
• The size of trade flows are much smaller than
the level of foreign exchange volumes.
© 2002 by Stefano Mazzotta
3. The Economic Approaches
18
Overview
• There are two basic models of exchange
rates: monetarist and Keynesian.
• Some models try to combine the two
approaches, keeping the Keynesian
reasoning for the short run and the monetarist
one for the long run.
• Both models reach opposite conclusions.
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Monetarists
• Also called the Chicago School.
• The exchange rate reflects the relative price
of money supplies in two countries.
• For example, if a country creates too much
money, the result will be purely nominal: high
inflation and weak currency.
• It is equivalent to the PPP conclusions.
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Keynesians
• Also called disequilibrium theory.
• The exchange rate reflects “real” developments.
• Frictions in the real economy cause goods prices to
adjust slowly while nominal exchange rates adjust
quickly. Therefore, changes in nominal exchange
rates propagate into changes in real exchange rates.
• High interest rates will attract capital: It is the
opposite to the Fisher effect conclusion.
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4. The Asset Pricing
Approaches
22
Assumptions
• Currencies are like any other financial asset.
• The price of a given currency (i.e. exchange
rates) is determined by investors’ desire to
hold assets denominated in that currency.
• This desire depends on investors’
expectations of the future worth of assets
they hold and on investors’ risk preferences.
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Intuition
• Current international trade flows should
not affect exchange rates if there are
already expected by the market
participants.
• The volatility of exchange rates is the
consequence of the news assimilation
process.
© 2002 by Stefano Mazzotta
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Conclusions
• News: It is important to specify the types of
news that affect exchange rates; It is even
better to quantify their effect.
• Central Banks: As an institutional “news
provider”, their behavior needs to be
modeled.
• Risk: The risk preferences and perceptions of
foreign exchange market participants are
crucial.
© 2002 by Stefano Mazzotta
5. Forecasting
Different methods for
different questions
26
• Market efficiency: are exchange rates random
walk?
• Econometric models: can we quantify the
relationship between exchange rates and
their determinants?
• Technical analysis: do exchange rates past
values tell us anything about future values?
© 2002 by Stefano Mazzotta