Fe rate determntn &forcastng

Copyright © 2010 Pearson Prentice Hall. All rights reserved.
Chapter 10
Foreign
Exchange Rate
Determination
and Forecasting

Copyright © 2010 Pearson Prentice Hall. All rights reserved. 10-2
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.

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.

Exhibit 10.1 The Determinants of
Foreign Exchange Rates

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.

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.

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.

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.

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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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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• 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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• 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 10.3 Comparative Daily Exchange
Rates: Relative to U.S. Dollar

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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:
• 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:
• 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 10.6 Daily Exchange Rates:
Argentine Pesos per U.S. Dollar

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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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• 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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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 term
• There is, therefore, something of a
fundamental equilibrium path for a
currency’s value.

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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.

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Exhibit 10.8 Differentiating Short-Term
Noise from Long-Term Trends

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Exhibit 10.9 Exchange Rate Dynamics:
Overshooting

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Technical Analysis
• An attempt to exploit recurring and
predictable patterns in stock prices
• Technicians’ beliefs:
– Shifts in market fundamentals can be
discerned before their impact is fully
reflected in prices
– Market fundamentals can be perturbed by
irrational factors
• These presumptions are in contradiction
with the weak form of the EMH

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Term Spread: A Leading Technical
Indicator

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Trends and Charting
• The Dow theory
– Primary trend
– Secondary or intermediate trends
– Tertiary or minor trends
– Support and resistance levels
• Recent variations
– The Elliot wave theory
– The theory of Kondratieff waves

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Dow Theory Trends

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Actual and Simulated Levels for
Stock Market Prices of 52
Weeks (Figure 11.7)

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Actual and Simulated Levels for
Stock Market Prices of 52
Weeks (Figure 11.8)

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Price Charts
• Moving averages
• Bollinger bands
• MACD (moving average
convergence/divergence)
• Stochastic indicator (oversold/bought)
• Volume

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Moving Averages
• Average calculated on last n periods
such as 200-day or 50-day
• Price or shorter average crossing the
longer average is said to predict a
change in direction

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Moving Average for Microsoft

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Chart of CNQ (unauthorized)

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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?

Additional
Chapter
Exhibits
Chapter 10

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Exhibit 10.2 The Economies and
Currencies of Asia, July–November
1997

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Exhibit 10.4 Argentina’s Economic
Performance, 1991–2000

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Exhibit 10.5 Argentina’s Debt and
Key Balances, 1991–2000

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Exhibit 10.7 Exchange Rate

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Exhibit 1 Monthly Average
Exchange Rates: US$/€

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Exhibit 2 Monthly Average Exchange
Rates: Japanese Yen per U.S. Dollar

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