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Foreign Exchange

Rate Determination

and Forecasting

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The Goals of Chapter 12

Summarized the theories to determine the exchange

rate, including the purchasing power parity approach,

the balance of payments approach, the monetary

approach, the asset market approach, and the

technical analysis

Introduce the crises in emerging markets, including the

Asian crisis in 1997 and the Argentine crisis in 2002

Discuss the forecasting of the exchange rate in

practice

10-2

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Foreign Exchange RateDetermination

10-3

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Foreign Exchange RateDetermination Exchange rate determination is complex

The three major schools of thought are the balance of

payments approach (Ch 4), international parity

conditions (Ch 7), and the asset market approach

The exhibit on the next slide provides an overview of the

many determinants of exchange rates

In addition to focusing on the asset market approach,

the monetary approach and the technical analysis are

also introduced in this chapter

These are not competing but rather complementary

theories, so understanding all of them can enhance

our ability to capture the complexity of global

currency markets and exchange rates

10-4

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Exhibit 1.1 The Determinants ofForeign Exchange Rates

10-5

International Parity Conditions (Ch 7)1. Relative inflation rates (RPPP)

2. Relative interest rates (international Fisher effect)

3. Forward exchange rates

4. Interest rate parity (IRP)

Balance of Payments (Ch 4)1. Current account balances

2. Portfolio investment

3. Foreign direct investment

4. Official monetary reserves

5. Exchange rate regimes

Asset Market Approach (Ch 10)1. Relative real interest rates

2. Prospects for economic growth

3. Supply & demand for financial assets

4. Outlook for political stability

5. Speculation & market liquidity

6. Contagion & corporate governance

SpotExchange

Rate

Monetary Approach

Technical Analysis

Most determinants of the exchange rate, e.g., the balance of BOP, the inflation rates, the nominal and real interest rates, and

the economic prospects, are also in turn affected by changes in the exchange rate

In other words, they are not only linked but mutually determined

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Foreign Exchange RateDetermination

In addition to gaining an understanding of the basic

theories or determining factors for the exchange rate, it

is equally important to gain the following knowledge

which could affect the exchange rate markets

1. The complexities of international political economy

Foreign political risks have been much reduced in recent years

because more countries adopted democratic form of

government, so capital markets became less segmented from

each other and more liquid

2. Societal and economic infrastructures Infrastructure weakness were the major reasons of the exchange

rate collapses in emerging markets in the late 1990s

3. Random political, economic, or social events

For example, recent occurrences of terrorism may increase the

political risks and affect the exchange rate market10-6

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Exchange Rate Determination:The Theoretical Thread

10-7

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This section will provide a brief overview of the manydifferent theories to determine exchange rate and their

relative usefulness in forecasting

The theories discussed in this section include

Purchasing power parity approach Balance of payments (flows) approach

Monetary approach

Asset market approach

Technical analysis

10-8

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Exchange Rate Determination:The Theoretical Thread The theory ofPurchasing Power Parity states that

the exchange rate is determined as the relative prices

of goods

PPP is the oldest and most widely followed exchange rate

theory

Paul Krugman, Nobel Prize laureate in Economics in 2008,

said that Under the skin an international economist lies a

deep-seated belief in some variant of the PPP theory of the

exchange rate

Most exchange rate determination theories have PPP

elements embedded within their frameworks

However, PPP calculations and forecasts are plagued with

structural differences across countries (e.g., different tax

rules or many non-tradable production factors) and

significant challenges of data collecting in estimation10-9

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The Balance of Payments (Flows) approach argues thatthe equilibrium exchange rate is determined through thedemand and supply of currency flows from current and

financial account activities

The BOP method is the second most utilized theoretical

approach in exchange rate determination Today, this method is largely dismissed by academics , but practitioners

still rely on different variations of the theory for decision making

This framework is appealing since the BOP transaction data is

readily available and widely reported

Critics may argue that this theory emphasizes on flows of

currency, but stocks of currency or financial assets of

residents play no role in exchange rate determination

The monetary approach considers the currency stocks of residents

The asset market approach argues that exchange rates are altered byshifts in the supply and demand of financial assets 10-10

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The Monetary Approachstates that the supply anddemand for currency stocks, as well as the expectedgrowth rates of currency stocks, will determine theprice level or the inflation rate and thus explain changesof the exchange rate according to PPP

The arguments are all about currency stocks of residents

The inference is to link the demand or the supply of currencieswith residents behavior to adjust the stock of currencies

Main results of the monetary approach are as follows:

Currency supply domestic currency depreciation1. Currency supply supply of currency > demand of

currencyresidents current currency holding > residents

desired currency holdingresidents spend the currencyprice level according to PPP, domestic currency depreciates

2. Domestic currency supply growth rate > foreign currency supplygrowth rate domestic currency depreciates vs. foreign currency10-11

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Interest rate domestic currency depreciation1. Interest rate opportunity cost for residents to hold the

currency increases demand of currency residentscurrent currency holding > residents desired currencyholdingresidents spend the currencyprice level according to PPP, domestic currency depreciates

2. Increase of domestic interest rate > increase of foreign interestrate domestic currency depreciates against foreign currency

Real income domestic currency appreciation1. Real income (= real GDP = outputs of products and services ) number of transactions demand of currency residents current currency holding < residents desiredcurrency holdingresidents decrease the spending of thecurrencyprice level (or because the supply of products andservices , price level and less currency is spent to achieve thesame utility) according to PPP, domestic currency appreciates

2. Domestic real income growth rate > foreign real income growth

rate (domestic economic growth > foreign economic growth)domestic currency appreciates against foreign currency 10-12

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The monetary approach omits a number of factors: The failure of PPP to hold in the short to medium term

The change of the interest rate and the real income will

affect the economic activities and thus affect the currency

supply

In the above inference, however, the change of the interest

rate and the real income affect only the currency demand

Currency demand appearing to be relatively unstable over

time

There are many factors other than the interest rate and the realincome to affect the money demand, e.g., the economic boom

or recession, so the money demand is difficult to be predicted

10-13

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The Asset Market Approach argues that theexchange rate should be determined by expectations

about the future of an economy, not current trade

flows

Since the prospect of an economy is reflected on thedemand of financial assets in that economy, the asset

market approach believes that changes of exchange

rates are affected by changes of the supply and

demand for a wide variety of financial assets: Shifts in the supply and demand for financial assets alter

exchange rates (not the demand and supply of financial

assets determine the exchange rate)

The asset market approach is also called the relative price of

bonds or portfolio balance approach10-14

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More specifically, if the demand for domestic financial assetsincreases, the demand for the domestic currency will increase,

which could results in the appreciation of the domestic

currency

Changes in monetary and fiscal policy alter expected returns

and perceived relative risks of financial assets, which in turn

alter the demand and supply of financial assets and thus

exchange rates (In the 1980s, many macroeconomic theories

focused on this topic)

Later I will introduce the determining factors in the assetmarket approach in detail

10-15

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Technical analysis is based on the belief that thestudy of past price behaviors provides insights into

future price movements

Due to the poor forecasting performance of many

fundamental theories, the technical analysis draws moreattention and becomes popular

The primary assumption of the technical analysis is that the

movements ofany market driven price (e.g., exchange

rates) must follow trends

More specifically, technical analysts, traditionally referredto as chartists, focus on price and volume data to identify

trends that are expected to continue into the future and next

exploit trends to make profit

10-16

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The Asset MarketApproach to Forecasting

10-17

h k h

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The Asset Market Approachto Forecasting The asset market approach assumes that the motives of

foreigners to hold claims in one currency depends onan extensive set of investment considerations ordrivers:

1. Relative real interest rates (an important concern for

investing in foreign bonds and money market instruments)

2. Prospects for economic growth (the major reason for cross-

border equity investment and foreign direct investment)

3. Capital market liquidity (Cross-border investors are not

only interested in investing assets to earn higher returns, butalso in being able to sell assets quickly for fair market value)

4. A countrys economic and social infrastructure (which is

an indicator of that countrys ability to survive in unexpected

external stocks)

10-18

h k h

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The Asset Market Approachto Forecasting

5. Political safety (which is usually reflected in political risk

premiums for a countrys securities)

6. Corporate governance practices (poor corporate governance

practices can reduce the investing will of foreign investors)

7. Contagion (which is the spread of a crisis in one country to its

neighboring countries, and can cause an innocent country toexperience capital flight and a resulting depreciation of its

currency)

8. Speculation (can cause a foreign exchange crisis or make an

existing crisis worse)

In summary, the asset market approach believes that the above

factors affect the motives of investments from both domestic

and foreign investors and thus affect the exchange rate

10-19

Th A M k A h

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Foreign investors are willing to hold securities andundertake foreign direct or portofolio investment in

highly developed countries based primarily on

relative real interest rates and the outlook for

economic growth and profitability

The experience of the U.S. illustrates why some

forecasters believe that exchange rates are more

heavily influenced by economic prospects than by the

current account For 1981-1985, the US$ strengthened despite growing

current account deficits

Relatively high real interest rates and good long-run prospects

cause heavy capital inflow into the U.S.

10-20

Th A t M k t A h

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For 1990-2000, the US$ strengthened despite continued

worsening balances on current account

The US$ remained to be strong due to foreign capital inflow

motivated by rising stock and real estate prices, a low rate of

inflation, high real interest rates, and an irrational expectation

about future economic prospects

Actually, from 1995 to 2001, the Nasdaq index increased by a

factor of more than 6

After the terrorists attacked the U.S. on September 11, 2001

A negative reassessment of long-term prospects due to the

newly formed political risk in the U.S. The drop of the stock markets and a series of failures in

corporate governance of large corporations further led to a large

withdrawal of foreign capital from the U.S.

According to both the BOP approach and the asset market

approach, the US$ depreciated since then10-21

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Illustrative Cases inEmerging Markets

10-22

Di ilib i E h R t

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Disequilibrium: Exchange Ratesin Emerging Markets

The asset market approach is also applicable toemerging markets, however, not only the relative real

interest rates and the prospects for economic growth

but also additional factors contribute to exchange rate

determination (see Slides 10-18 and 10-19)

The Asian and Argentine crises are examined as illustrative

cases in this section

10-23

Ill t ti C

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Illustrative Case:The Asian Crisis of 1997 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 due to the following two

reasons

Rapidly economic expansion

Many Asian countries pegged its currency at a fixed

exchange rate with the US$, so their currencies appreciated

with the US$ being strong after 1995

The deficit of BOP generates the depreciation pressure To support their pegged exchange rates, Asian nations

require to attract net capital inflow

The most visible roots of the crisis were the excess capital

inflows into Thailand in 1996 and early 199710-24

Ill t ti C

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Illustrative Case:The Asian Crisis of 1997

Thai banks continued to raise capital internationally,

and extended credit to a variety of domestic investmentsand enterprises beyond what the Thai economy couldsupport

As the investment bubble expanded, market

participants questioned the ability of the economy torepay the rising amount of debt, so the Thai baht wasattacked by international speculation CFs (factor 8)

The Thai government intervened directly (using up

precious currency reserves) and indirectly by raisinginterest rates in support of the currency (to stop thecontinual outflow)

On July 2, 1997, the Thai central bank allowed the baht

to float, and the Thai baht against US$ fell 17% inseveral hours and 38% in 4 months 10-25

Ill t ti C

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Illustrative Case:The Asian Crisis in 1997 The international speculators attacked a number of

neighboring Asian nations, some with and some

without characteristics similar to Thailand (factor 7)

It is the Asias own version of the tequila effect

Tequila effect is the term used to describe how the

Mexican peso crisis of December 1994 quickly spread to

other Latin American currency and equity markets

The spread of the financial panic is termed contagion

The Philippine peso, the Malaysian ringgit, and

Indonesian rupiah all fell in the months followingthe July baht devaluation

10-26

E hibit 10 3 C ti D il

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Exhibit 10.3 Comparative DailyExchange Rates: Relative to the US$

10-27

E hibit 10 2 Th E i d

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Exhibit 10.2 The Economies andCurrencies of Asia, JulyNovember 1997

Due to the not-completely-free-convertible features, the Chinese yuan was notdevalued, but there was rising speculation that Chinese government would devalue it

soon for competitive reasons (but it did not)

The Hong Kong dollar survived, but with great expense to the central banks foreign

exchange reserves

Although Taiwan was with enough foreign exchange reserves, Taiwan caught themarkets imbalance with a surprise competitive depreciation of 15% in Oct. 1997

10-28

Ill st ati e Case

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The Asian economic crisis (which was much more

than just a currency collapse) had other reasons besidestraditional balance of payments difficulties: Corporate socialism

In Asia, because the influence of governments, even in theevent of failure, it was believed that governments would not

allow firms to fail, banks to close, and workers to lose their jobs This kind of policy provided the stability of the economy, but

when business liabilities exceeded the capacities ofgovernments to bail businesses out, the crisis happened

Overinvestment in Asian countries (factor 2)

Due to the low interest rate in both Japan and the U.S., toomuch capital for portfolio investments flowed into Asiancountries, which supports the bubble in Asian countries

Banking liquidity and management (factors 3, 4, and 6) The lack of transparency and monitoring mechanisms

encouraged banks to underestimate the credit risk of firms andexpand the lending business too much 10-29

Illustrative Case:

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Banks did not hedge exchange rate risk while raising

international capital, so when the domestic currency depreciatedin the financial crisis, they suffered further loss

During the financial crisis, banks themselves suffer the liquidityproblem, so banks cannot provide liquidity to firms forconducing their businesses

Political risk(factor 5) Investors did not have confidence in the political stability of

southeast Asian countries. So, if there is any sign for politicalproblems, the capital out flowed from those countriesimmediately

After the crisis, the slowed economies of this regionquickly caused major reductions in world demands formany commodities and thus the decline of thecommodity prices, e.g., oil, metal, agricultural

products, etc., which is part of the reasons for theRussian crisis in 1998 10-30

Illustrative Case:

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Illustrative Case:The Argentine Crisis of 2002 In order to eliminate the hyperinflation problem that

had underminedthe nations standard of living inthe 1980s, a currency board structure was

implemented in Argentina in the early 1990s In 1991, the Argentine peso had been fixed to the US

dollar at a one-to-one rate of exchange

The reason why the currency board regime can

control the inflation problem: Limit the growth rate in the countrys currency supply to

the rate at which the country receives net inflows of U.S.dollars as a result of trade growth and general surplus

This rigorous restriction eliminates the power of politiciansto affect the currency policy in both good and bad ways,

e.g., the government lost the ability to utilize the monetarypolicy to stimulate the economy 10-31

Illustrative Case:

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Illustrative Case:The Argentine Crisis of 2002

Although the hyperinflation was cured by the restrictive monetary

policy, this policy also slowed economic growth in the coming years The real GDP shrank in 1999 (-3.5%) and 2000 (-0.4%), and the

unemployment rate rose to about 15% since 1995

In order to demonstrate the governments unwaveringcommitment to maintaining the pesos value parity with

the dollar, the Argentine government allowed banks toaccept deposits in either pesos and dollars

However, there was substantial doubt in the market thatthe Argentine government was able to maintain the fixed

exchange rate10-32

Illustrative Case:

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By 2001, after three years of recession, three important

problems with the Argentine economy became

apparent:

The Argentine peso was overvalued (factor 2)

The inability of the pesos value to change with the market

forces (e.g., economic growth, competitive power of firms, and

so on) led many to believe increasingly that it was overvalued

Argentine exports became some of the most expensive in all of

south America, as other countries depreciated their currencies

against the US$ over the decade, but not the Argentine peso

Therefore, the deficit of the current account deteriorated from

$0.65 billion (in 1991) to $8.9 billion (in 2000)

10-33

Illustrative Case:

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Illustrative Case:The Argentine Crisis of 2002 The currency board regime had eliminated monetary policy

alternatives for macroeconomic policy The rule of the currency board regime eliminated monetary policy

as an avenue for macroeconomic policy formulation, leaving only

fiscal policies (e.g., government spending and tax policy) for

economic stimulation

In fact, due to the continuous deficit of the BOP, Argentina couldonly adopt the contraction monetary policy from 1991 to 2000

The Argentine government budget deficit, i.e., spending, was

out of control

As the unemployment rate grew higher, as poverty and social

unrest grew, government spending continued to increase to solvethese social and economic problems

Without the proportional increase of tax receipts, Argentine

government then turned to raise international debts to aid in the

financing of its spending (the total foreign debt had double from

1991 to 2000)10-34

Illustrative Case:

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Illustrative Case:The Argentine Crisis of 2002 As economic conditions continued to deteriorate,

depositors, fearing that the peso would be devalued,withdrew their peso cash balances and then

converted pesos to US$, which speeded up the

currency collapse

The government, fearing that the increasing financial

drain on banks would cause their collapse, close the

banks on December 1, 2001 to stop the flight of

capital out of Argentina

During the political chaos in the beginning of 2002

(factor 5), Argentina declared the largest sovereign

debt default in history that it would not be able to

make interest payments due on $155 billion in

sovereign (government) debt 10-35

Illustrative Case:

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On January 6, 2002, the Argentine government

decided that the peso was devalued from Ps1.00/$ to

Ps1.40/$ 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 (factor 3)

The provincial governments began printing their all

money, promissory notes Because the notes were issued by the provincial

governments, not the federal government, people and

business would not accept notes form other provinces

10-36

Illustrative Case:

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The population became trapped within its own province,

because their money was not accepted in the outsideworld in exchange for goods, services, travel, or

anything else

On February 3, 2002, the Argentine government

announced that the peso would be floated and the banks

would reopen

In February and March 2002, negotiations between the

IMF and Argentina continued as the IMF demanded

increasing fiscal reform over the growing government

budget deficits and bank mismanagement (factor 4)

Argentinas experience has proved that it is not easy to

adopt the currency board system of a firmly fixed

exchange rate for an economy 10-37

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Forecasting in Practice

10-38

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Although the three different schools of thought on

exchange rate determination (parity conditions,balance of payments approach, asset market approach)

make understanding exchange rates to be

straightforward, that is rarely the case

The large and liquid capital and currency markets followmany 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 thesetheories or need to be explained by considering more factors

(see the illustrative cases in the previous section)

As a consequence, numerous foreign exchange

forecasting services exist, many of which are provided

by banks and independent consultants 10-39

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Some multinational firms have their own in-house

forecasting capabilities Long-term forecasts may be motivated by a multinational

firms desire to initiate a foreign investment

Short-term forecasts are typically motivated by a desire to

hedge account receivables or payable for perhaps a period ofseveral months

Predictions can be based on fundamental theories

(usually used for long-term forecasts), various

econometric models (e.g., time series techniques whichinfer no theory but simply try to find relation between

future values and the past values), or technical analysis

of charts and trends (more suitable for short-term

forecasts) 10-40

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In technical analysis, exchange rate movements, similar

to equity price movements, can be divided into threecomponents:

Day-to-day movements (seemingly random)

Short-term movements from several days to several months

(temporarily deviations from the long-term trend)

Long-term trends

Forecasting for the long-run exchange rate movement can

depends on the economic fundamentals of exchange rate

determination, i.e., the inflation rates, interest rates, or theprospects of economies

Many researches suggest that the long-term exchange rate

exhibits the characteristic ofmean reversion, i.e., the exchange

rates eventually move back towards the mean or average

10-41

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In practice, a synthesis of the exchange rate forecast is

often adopted

From many theoretical and empirical studies, long-term

exchange rates do adhere to the fundamental principles and

theories outlined in the previous sections Fundamental

principles do apply in the long term There exists afundamental equilibrium pathfor a currencys value

In the short term, a variety of random events called noise

may cause currency values to deviate from their long-term

fundamental equilibrium path

10-42

Exhibit 1 2 Differentiating Short-Term

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Exhibit 1.2 Differentiating Short-TermNoise from Long-Term Trends

10-43

Time

Foreign currency per

unit of domestic currency

Fundamental

Equilibrium

Path

Political or social events or weak

infrastructure (e.g., the banking system)may drive the exchange

rate from the long-term path significantly

Short-term forces may induce

noiseshort-term volatility

around the long-term path

The long-term equilibrium path is not always apparent in the short term

(although relatively well-defined in retrospect)

Some studies also point out that the exchange rate itself may deviate in

something of a cycle or wave about the long-term path

Exhibit 1 3 Exchange Rate

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Exhibit 1.3 Exchange RateForecasting in Practice

10-44

financial condition

JPMorgan Chases Forecasting

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JPMorgan Chase s ForecastingAccuracy (US$/)

10-45

The above figure shows the forecast of JPMorgan Chase for the 90-day

US$/ exchange rate into the future

In February of 2004, it forecasted the exchange rate to move from $1.27/ to

$1.32/ , but in fact the realized exchange rate after 90 days is $1.19/ , which

illustrates the difficulty to forecast the movement of the exchange rate

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Predict exchange rate dynamics

Although various theories surrounding exchange ratedetermination are clear and sound, the difficulty is to

understand which fundamental theories are driving markets

at which time points

One example over exchange rate dynamics is the

phenomenon known as overshooting

The U.S. Federal Reserve announces an expansionary monetary

policy, and the markets react to this news through the

immediate depreciation in the exchange rate from S0 to S1(According to the asset market approach, currency supply

real interest rate of US$ capital outflow from the U.S.

US$ depreciates)

With the passing of time, the price impact of this monetary

policy starts working through the economy to increase the price

level. According to PPP, the equilibrium exchange rate, i.e., the

exchange rate in the long run, should depreciate to be S2 10-46

Exhibit 1 4 Exchange Rate Dynamics:

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Exhibit 1.4 Exchange Rate Dynamics:Overshooting

S0

t1 t2

S1

S2

Spot ExchangeRate ($/)

Overshooting

Time

The difference between S1 and S2 reflects the dominance of different

theoretical principles at different points in time (first is the asset market

approach and second is the PPP theory)

As a result, the initial higher value of S1 is often explained as an

overshooting of the longer-term equilibrium value of S2

Since the exchange rate is expressed as

US$ price per euro, S1 > S0 (S2 > S0)

represents the depreciation of the USdollars against the euros

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