Exchange Rate Determination

1
Foreign Exchange Rate Determination (or
chapter 5)
2
Agenda

• How BOP explains exchange rates?
• Asset market approach to exchange rates.
• Forecasting in practice.
• How different theories combine to explain recent
  currency crises?

3
Exchange Rate Determination

• Basic approaches
• Parity conditions
• Flow (BOP) approach
• Stock (asset market) approach
• In addition, need to account for important social
  economic events, such as
• Infrastructure weaknesses,
• Speculation,
• Cross-border FDI,
• Foreign political risks.

4
Flow (BOP) Approach

• Forex as a medium of exchange.

5
BOP Approach

• Fixed Exchange Rate Countries
• Government bears responsibility to ensure BOP
  near 0.
• If CACAP / 0, government must intervene
• If government lacks reserves, will have to
  devalue.
• Managed Float Countries
• To defend currency, may raise interest rates.
• gt raises cost of capital for domestic firms

6
Stock (Asset Market) Approach

• Forex as a store of value
• Willingness to hold monetary claims depends on
  relative real interest rates on countrys
  economic growth profitability.
• Asset approach forward looking discounted
  future value
• Movements in exchange rate reflect news.
• Current exchange rate is set to equilibrate
  risk-adjusted expected return on assets
  denominated in different currencies.

7
(No Transcript)
8
Asset Model Monetary Approach

• Spot exchange rate is relative price of two
  monies.
• Flexible price model Domestic good prices fully
  flexible
• If domestic money supply increases domestic
  currency will depreciate.
• If domestic real income Y rises/ domestic
  interest rate i falls, domestic currency will
  appreciate as money demand is increased
• Stick price model Goods prices are sticky (slow
  to adjust) relative to asset prices.
• Asset prices have to move by more than in
  flexible price case, in order for markets to
  reach equilibrium.

9
Asset Model Portfolio-Balance

• Portfolio-balance model has two financial assets
  (money bonds) and two countries (home
  foreign).
• Exchange rate establishes equilibrium in investor
  portfolios of domestic money domestic and
  foreign bonds.
• Balance between domestic and foreign bonds in a
  portfolio is positively related to expected
  excess return on domestic bonds over foreign
  bonds.
• Investors asset preferences may be similar
  across countries (uniform preference model), or
  investors may prefer assets of their home country
  (preferred local habitat model).

10
The Portfolio-Balance Approach
Effects of Macroeconomic Shocks on forex
11
Forecasting Techniques

• 3 general types of forecasts
• Intuitive expectations should be sufficient ?
  efficient market approach
• Monetary policy ? fundamental approach.
• History ? technical approach.

12
Efficient Market Approach

• Markets are efficient reflect all available
  information.
• Markets will follow random walk by changing only
  when unpredicted events occur (i.e. news). St
  ESt1.
• PPP can be interpreted as markets consensus
  forecast of future exchange rates if markets
  efficient Ft,1 ESt1 It.

13
Fundamental Approach

• Exceedingly technical. Widely used in banks.
• Heavy econometrics 3-step process
• Estimate structural model.
• Estimate future parameter values.
• Use the model to develop forecasts.

14
Technical Approach

• History repeats itself.
• Data mining in search of patterns.
• Largely reliant on short-term long-term moving
  averages and divining patterns in the graphs.
• Not well-regarded in academia ?, but extremely
  popular among traders ?.

15
Example of Technical Analysis
Source http//www.investavenue.com/article.html?I
D5761
16
Forecasting in Practice

• Short-term forecasts hedge receivable, payable,
  or dividend
• Long-term forecasts capital structure, entry
  mode of investment
• Cross-rate consistency.
• E.g. HQ forecasts Yen 120/, 1.50/Pound
• Regional managers forecast Yen 150/Pound.
• gt Inconsistency.
• Stabilizing expectations.

17
SHORT-RUN Floating Rate 1. Forward rates? 2.
Inflation? 3. Government interventions news
releases?
LONG-RUN Floating Rate 1. PPP inflation. 2.
Economic growth. 3. Technical analysis
long-term trends waves
18
Anatomy of a crisis -- Asia97

• What caused it? Supply driven net exporters
  became net importers.
• Thai banks had access to capital US debt at
  low rates.
• 1997 Thai Baht under attack due to countrys
  rising debt.
• Thai government intervened directly selling
  reserves indirectly raising interest rates.
• Massive currency losses and bank failures led to
  July 1997, central bank allowed Baht to float.
• Contagion Taiwan devaluation (15), Korea
  (18.2), Malaysia (28.6), Philippines (20.6)
  against the .
• Not affected Hong Kong and Chinese renminbi.
• Countries had similar characteristics corporate
  socialism, in-transparent corporate governance,
  banking liquidity and management.

19
Asian Crisis
Thailands Deteriorating Balance of Payments,
1991-1998Excess capital inflows, 1996 1997
Source International Financial Statistics, IMF
20
Thai Interest/Exch. Rate Disequilibria
360 days
21
Russian Crisis

• During 1995-1998, Russian borrowers (public
  private) tapped international markets for
  capital.
• Servicing debt a problem as US were required for
  payments
• Russian rouble operated under managed float w/in
  band of RU 5.75/ to RU 6.35/
• Even after 4.3bn IMF facility, rouble fell under
  attack August 1998
• Financing options dried up, debt issuance
  cancelled.
• Russia began printing money for domestic
  payments.
• Russia defaulted on foreign debt, first time
  Eurobond default.
• Postponed 43bn short-term debt 90-day
  moratorium on repayment of foreign debt.

22
Brazilian Crisis 1/ 1999(read on own)

• Continuing CA deficits and domestic inflation
  puts in 1998 pressure on real
• Heavy outflow of capital, stock market down.
• Central bank raised short-term interest rates 36
  -gt 41
• April 1999, real appreciated against the dollar.

23
Things to remember

• BOP and asset market approaches to exchange
  rates.
• Forecasting in practice.
• How different theories combine to explain recent
  currency crises Asia, Russia?