Transcript PPT Chapter5

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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Exhibit 5.1 The Determinants of
Foreign Exchange Rates
Parity Conditions
1.
2.
3.
4.
Relative inflation rates
Relative interest rates
Forward exchange rates
Interest rate parity
Is there a well-developed
and liquid money and capital
market in that currency?
Asset Approach
1.
2.
3.
4.
5.
6.
Relative real interest rates
Prospects for economic growth
Supply & demand for assets
Outlook for political stability
Speculation & liquidity
Political risks & controls
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Spot
Exchange
Rate
Is there a sound and secure
banking system in-place to support
currency trading activities?
Balance of Payments
1.
2.
3.
4.
5.
Current account balances
Portfolio investment
Foreign direct investment
Exchange rate regimes
Official monetary reserves
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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$
120
110
100
90
80
70
INSERT EXHIBIT 5.3
60
50
40
30
20
Philippine Peso
Thai Baht
Malaysian Ringgit
Indonesian Rupiah
10
Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep
97 97 97 97 97 97 97 97 97 98 98 98 98 98 98 98 98 98
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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 - $20 billion per year) was not
finding its way into internal investment and
external debt service.
• Capital flight began to accelerate, and hard
currency earnings flowed out of the country.
• As the Russian rouble operated under a
managed float, the Central Bank had to
intervene in foreign exchange markets to
support the currency if it came under pressure.
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Illustrative Case:
The Russian Crisis of 1998
• During the month of August, 1998, the Russian
government continued to drain its reserves and
had increasing difficulties in raising additional
capital in support of its reserves on the
international markets.
• By mid-August, the Russian Central Bank
announced it would allow the rouble to fall,
postponed short-term domestic debt service
and initiated a moratorium on all repayment of
foreign debt owed by Russian banks and
private borrowers to avert a banking collapse.
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Exhibit 5.4 Daily Exchange Rates:
Russian Rubles per US$
27.5
25.0
22.5
20.0
17.5
15.0
12.5
10.0
7.5
5.0
Jun
98
Jul
98
Aug
98
Sep
98
Oct
98
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Nov
98
Dec
98
Jan
99
Feb
99
Mar
99
Apr
99
May
99
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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
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
26
2
9
16
23
Jan 2002
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30
8
13
20
Feb 2002
27
8
13
Mar 2002
20
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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 inhouse 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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Exhibit 5.10 Differentiating ShortTerm Noise from Long-Term Trends
Foreign currency per
unit of domestic currency
Technical or random events
may drive the exchange
rate from the long-term path
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Fundamental
Equilibrium
Path
Time
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Exhibit 5.11 Exchange Rate Dynamics:
Overshooting
Spot Exchange
Rate, $/
S1
Overshooting
S2
S0
t1
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t2
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?
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