Chapter 3: FX rate determination

1
Chapter 3 FX rate determination

• No general all-explaining theory exists
• Long run
• Parity conditions
• Short run
• Forward rates
• Technical analysis
• Fundamental analysis into inflationary concerns,
  etc.

2
The BOP Approach

• Balance of Payments
• Current Account (Exports - imports)
• Capital Account (Transactions related to
  fixed assets)
• Financial Account (Flows related to
  financial investments)
• Reserve Balance

3

• The BOP is supposed to balance
• e.g. typically, a current account surplus
  (exportsgtimports) is countered by a
  capital/financial account deficit
  (capital/financial outflowsgtinflows)
• Under a fixed exchange rate system
• monetary authorities are in charge of balancing
  the BOP
• Example
• Elbonian exports gt imports
• foreigners demand E to pay for the exports
• shortage of E due to low imports
• demand for E gt supply

4

• Elbonian govt must react to the Current Account
  imbalance
• intervention selling domestic currency for
  foreign currencies
• If Current Account deficits are persistent, risk
  of running out of reserves
• devaluation?
• So, under fixed exchange rates, BOP can indicate
  pressure on the currency
• Under managed float, interest rates often used to
  induce financial flows
• disadvantage high interest rates hurt the
  domestic economy
• Why is BOP less of a forecasting tool under
  floating rates?

5
International parity conditions

• Theoretical macro-economic relationships
  affecting the exchange rates
• prices or price changes
• interest rates
• forward exchange rates

6
Arbitrage

• Arbitrage the profit is known with certainty -
  no risk
• In contrast, in speculation trading is done with
  an expectation that a profit will be earned -
  risky

7

• What happens when someone finds an arbitrage
  opportunity?
• They execute as many transactions as possible
• Prices are affected through supply and demand and
  the arbitrage opportunity disappears.
• Arbitrage is a strong market force
• Note In practice, market imperfections may cause
  the FX markets not to conform to the parity
  conditions
• Reliability of a parity condition depends on its
  arbitrageability

8
Purchasing Power Parity (PPP)

• Relationship between the FX rate between two
  countries and the corresponding price levels.
• Based on the notion that goods and services
  should cost the same in different countries.

9
Law of One Price

• No arbitrage condition
• The domestic price and the foreign price of a
  good are equal when converted to the same
  currency P x S/ P
• Or S/ P/P
• A.k.a. Absolute PPP - spot exchange rate is
  determined by the relative prices of similar
  baskets of goods
• a unit of home currency has the same purchasing
  power around the world

10

• Example a car in Finland vs. US
• According to the Law of one price, P S/ x P
• So, S price of the car in Finland / price of
  the car in U.S
• This is absolute PPP using just one good
• what if this does not hold?
• S 56,000/36,469 1.5356 /

11
Relative PPP

• Any change in the differential rate of inflation
  between two countries is offset by an equal but
  opposite change in the spot rate
• Currencies with high inflation should depreciate
  relative to currencies with low inflation
• Often measured in terms of changes in the value
  of a basket of goods

12

• Example
• suppose Mexico has 10 inflation
• Peru has an inflation rate of 5
• After one year, one Mexican peso would buy less
  than one unit of Peruvian new sol
• We would expect the value of peso to decline
  relative to the new sol

13
Does PPP hold in the real world?

• The relationship can be easily tested with a
  regression model
• In academic studies, PPP has not received much
  support
• The only empirical merit for PPP is in long term
  forecasting

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• Why might PPP not work?
• Arbitrage only works for tradeable goods
• Are Big Macs tradeable?
• How about services?
• Barriers to trade
• transportation costs
• many goods are not perfect substitutes
• cross-country differences in tastes and
  preferences
• imperfect exchange rate pass through (see Exhibit
  3.7, p. 73)

15
International Fisher Effect (IFE)

• Recall domestic Fisher effect
• IFE - when interest rate difference between two
  countries changes ? the spot exchange rate
  changes to offset the interest rate change
• Suggests that currencies with high interest rates
  will depreciate (because high interest rates
  reflect high expected inflation)

16
IFE parity condition

• expect / to decrease
• depreciates, why?
• What is the real gain from higher interest if
  IFE holds?

17

• The expected change in the spot rate an be
  estimated by i - i
• .03 - .06 -.03 ? expect to depreciate by
  about 3 wrt
• Relies on assumption that real interest rates
  across countries are the same
• IFE is based on PPP, and therefore does not often
  hold in practice.

18
Covered Interest Arbitrage

• riskless activity in the FX market that equalizes
  the yield on a domestic financial asset with that
  of a like foreign financial asset, where both
  yields are know with certainty today.
• Forces the interest rates and the forward rates
  to be in alignment between two countries

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• Example
• i 5 i 8
• S 1.50/ F 1.48/
• You can borrow up to 1,000,000 or 666,667
• Borrow 1,000,000
• Buy at spot rate
• 1,000,000/1.50 666,667
• Invest 666,667
• (In a year, it will grow to 666,667(1.08)
  720,000 )
• Sell 720,000 forward at fwd rate
• 720,000 (1.48) 1,065,600
• In a year, pay off the loan
• 1,000,000 (1.05) 1,050,000
• Riskless profit of 15,600

20
Interest rate parity (IRP)

• the forward rate differs from the spot rate by a
  sufficient amount to offset the interest rate
  differential between two currencies
• IRP equation
• Ftd/f/S0d/f (1id)/(1if)t
• Or fwd premium
• (1id)/(1if)t-1

21

• Assuming
• direct quotes HC/FC
• foreign and domestic assets are same in terms of
  risk
• If covered interest arbitrage opportunities do
  not exist, then interest rate parity holds
• What if interest rate parity does not hold?
• Notice similarity between IFE and IRP - the only
  difference is using future spot rate rather than
  forward rate

22
Uncovered interest speculation

• Identical to CIA, except uses the future spot
  rate in place of forward rate
• Risky, since the future spot rate is unknown
• Higher profit potential since the profits are not
  locked in either

23
Fwd rate as an unbiased predictor (FRUP)

• Forward rate exchange rate you can lock in
  today for a future transaction
• FRUP On average, the forward rate predicts the
  future spot rate correctly
• Test
• Findings Typically ß?1

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• Example
• Spot rate 1.4606/
• 3-mo fwd rate 1.4524/
• According to FRUH, we would expect the spot rate
  in 3 months to be 1.4524/
• Or, at least the forward rate is predicting
  appreciation
• What happened?

25
Parity conditions in equilibrium

• In equilibrium, the parity conditions are related
  to each other
• See exhibit 3.3, p. 65
• They connect
• Forward premium
• Expected spot rate change
• Expected inflation difference
• Interest rate differential

26
The Asset market approach

• Expectations about economic, political, and
  social factors determine fx rates
• What makes investors decide to hold a currency?
• A currency that is expected to gain value is a
  better investment
• According to the asset market approach, the value
  change is forecasted
• The BOP describes the past why should it affect
  the value of the currency today?

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• A stable currency will attract investors
• Expectation of stability leads investors to view
  the currency as a good vehicle to store value
  in
• the consequent demand for assets denominated in
  the currency will further strengthen it
• Why does the U.S. dollar often gain value at
  times of international uncertainty?
• What has been different since Sept, 2001?

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Forecasting FX rates

• Why?
• Changes in FX rates affect our cash flows.
• A/R and A/P
• price competitiveness of our products
• exports
• imports
• investment analysis of capital projects
• portfolio investment
• What is different about these different motives?

29
What if FX markets are efficient?

• Weak-form efficiency
• today's exchange rate reflects all information
  about the past exchange rate movements
• Semi-strong-form efficiency
• all relevant public information is reflected in
  today's exchange rate
• Strong-form efficiency
• all relevant public and private information is
  reflected in today's exchange rate

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• If FX markets are efficient, forecasting is
  likely a waste of time and money
• Empirical evidence does tend to support
  efficiency
• But, . . .
• the stakes can be high
• is gov't intervention predictable?
• some markets are segmented
• many nations use fixed exchange rates

31
Uses of Forex forecasts

• For speculators
• For MNCs
• Strategic planning
• Budgeting
• Current asset/liability management
• To hedge or not to hedge?
• Approaches
• In house vs. commercial forecasts
• Form point estimate / interval estimate /
  direction of movement

32
Long-term vs. short-term

• Short-term forecasting is more of a concern for
  companies making hedging decisions on their
  existing assets/liabilities
• Requires accuracy
• Long-term forecasting is needed when making
  capital investment decisions
• What is the yen going to be worth in 10 years???
• While it is next to impossible to accurately
  predict exchange rates, forecasting the direction
  of change may be adequate

33
Forecasting methods

• In a simplified world
• Using international parity conditions
• Works better for long-run forecasts
• In the real world
• Under fixed vs. floating regimes
• Floating economic forces market psychology (?)
• Fixed economic forces political behavior
• Fundamental Analysis
• Technical Analysis
• Market Based Analysis
• Combination of all of the above

34
Choice of methods

• Depends on the rate system
• Under the fixed system, the focus is on
  predicting political actions
• Under floating rates, focus on the market forces
  expected to affect the rate
• Depends on the time span
• In short term, the fixed rate will only change
  upon extreme political events
• Short-term floating rates are challenging to
  predict
• In long-term, the fundamental analysis can
  predict trends

35
Fundamental analysis

• Using the economic fundamentals to predict fx
  rates
• Parity conditions, BOP, asset market approach
• Problems with fundamental analysis
• Numerous fundamental factors affect exchange
  rates, their composition and relative importance
  varies over time
• Some factors cannot be directly measured
• Some factors have instantaneous impact

36
Technical Analysis

• Forecasting future movements and trends in
  exchange rates, based on their past performance
• Assumes that weak-form efficiency does not hold
• Problems
• Focus on short term movements
• No model with consistent performance exists (as
  far as we know)
• Does not typically give the magnitude of the
  expected change

37
Evaluation of Forecast Performance

• How do we measure accuracy?
• Closest to the realized spot rate?
• Measuring absolute forecast error
• Or on the correct side of the present forward
  rate?
• Determining whether there is a consistent bias in
  forecasts
• Accuracy vs. Correctness