ECW2721 Lecture W8 Forex

8/10/2019 ECW2721 Lecture W8 Forex

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WEEK 8

Chapter 9

TheDeterminants of

Exchange Rates


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Belarus National Bank has announced 56% devaluation of its national currency theBelarusian rouble, thus evoking panic amongst Belarus residents, hurriedly stocking upfood and other goods.


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Learning Objectives

To understand the various approaches to forecasting the exchange

rates

To understand the strengths and limitations of each approach

To understand exchange rate movements over the short and long

term.

Reading:

Australian edition (Chapter 9)Global edition (Chapter 9)

Week 8 4


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Foreign Exchange RateDetermination

Exchange rate determination is complex. Exhibit 9.1 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 ofpayments approach, asset market approach), andsecondly by the individual drivers within thoseapproaches.

These are not competingtheories but rathercomplementarytheories.


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Foreign Exchange RateDetermination

Without the depth and breadth of the variousapproaches combined, our ability to capture thecomplexity of the global market for currencies islost.

In addition to gaining an understanding of the basic

theories, it is equally important to gain a workingknowledge of:

the complexities of international political economy;

societal and economic infrastructures; and,

random political, economic, or social events that affect theexchange rate markets.



Exhibit 9.1 The Determinants ofForeign Exchange Rates



Exchange Rate Determination:The Theoretical Thread

The previous exhibit, with its tripartitecategorization of exchange rate theory is agood start but in our humble opinion isnot robust enough to capture the multitudeof theories and approaches.

Therefore, in the following slides, we willintroduce several additional streams ofthought.


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The theory ofpurchasing power parityis themost widely accepted theory of all exchangerate determination theories: The long-run equilibrium exchange rate is

determined by the ratio of domestic prices (Pd)relative to foreign prices (Pf).

Most exchange rate determination theories havePPP elements embedded within theirframeworks.

PPP calculations and forecasts are howeverplagued with structural differences acrosscountries and significant data challenges inestimation.


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The balance of payments approachis thesecond most utilized theoretical approach inexchange rate determination: The basic approach argues that the equilibrium

exchange rate is found when currency flows matchup vis--vis current and financial account activities.

CA = -FA or CA = FA

This framework has wide appeal as BOP transactiondata is readily available and widely reported.

Critics may argue that this theory does not takeinto account stocks of money or financial assets.


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Exchange Rate Determination: TheTheoretical Thread

The monetary approach in its simplest formstates that the exchange rate is determinedby the supply and demand for nationalmonetary stocks, as well as the expected

future levels and rates of growth ofmonetary stocks.

Other financial assets, such as bonds arenot considered relevant for exchange rate

determination, as both domestic and foreignbonds are viewed as perfect substitutes.


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The asset market approachargues thatexchange rates are determined by thesupply and demand for a wide variety offinancial assets: Shifts in the supply and demand for financial

assets alter exchange rates.

Changes in monetary and fiscal policy alterexpected returns and perceived relative risks offinancial assets, which in turn alter exchangerates.


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The forecasting inadequacies of fundamentaltheories has led to the growth andpopularity of technical analysis, the beliefthat the study of past price behaviorprovides insights into future pricemovements.

The primary assumption is that any market

driven price (i.e. exchange rates) followstrends.


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The Asset Market Approachto Forecasting

The asset market approachassumes that whetherforeigners are willing to hold claims in monetary formdepends on an extensive set of investment considerationsor drivers (among others):

Relative real interest rates

Prospects for economic growth Capital market liquidity

A countrys 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 Approachto Forecasting

Foreign investors are willing to holdsecurities and undertake foreign directinvestment in highly developed countriesbased primarily on relative real interest

rates and the outlook for economic growthand profitability.

The asset market approach is alsoapplicable to emerging markets; however in

these cases, a number of additionalvariables contribute to exchange ratedetermination (previous slide).


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Currency Market Intervention(Why?)

Foreign currency intervention is the activemanagement, manipulation, or interventionin the markets valuation of a countryscurrency.

Why Intervene? Fight inflation (strong currency)

Fight slow economic growth (weak currency)


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Currency Market Intervention(How?)

Methods of intervention are determined bymagnitude of a countrys economy,magnitude of trading in its currency, andthe countrys financial market development

Direct Intervention the active buying and selling of the domestic

currency against foreign currencies

If the goal is to increase the value, then thecentral bank buys its own currency

If the goal is to decrease the value, then thecentral bank sells its own currency


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If bank intervention is insufficient, thencoordinated intervention may be used wherebyseveral central banks agree on a strategy toincrease or decrease a currency value.

Indirect Intervention is the alteration of economicor financial fundamentals which are thought to bedrivers of capital to flow in and out of specificcurrencies. Increase real rates to strengthen a currency

Decrease real rates to weaken a currency


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Capital Controls are restrictions of access to foreigncurrency by the government by limiting the exchange ofdomestic currency for foreign currency.


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Disequilibrium: Exchange Ratesin Emerging Markets

Although the three different schools of thought on exchangerate determination (parity conditions, balance of paymentsapproach, asset approach) make understanding exchangerates appear to be straightforward, that it rarely the case.

The large and liquid capital and currency markets follow manyof 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 theassumptions underlying the theory.


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Illustrative Case: The Asian Crisis

The roots of the Asian currency crisis extendedfrom a fundamental change in the economics of theregion, the transition of many Asian nations frombeing net exporters to net importers.

The most visible roots of the crisis were the excess

capital inflows into Thailand in 1996 and early1997.

As the investment bubble expanded, somemarket participants questioned the ability of theeconomy to repay the rising amount of debt and

the Thai bhat came under attack.


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The Thai government intervened directly (usingup precious hard currency reserves) andindirectly by raising interest rates in support ofthe currency.

Soon thereafter, the Thai investment marketsground to a halt and the Thai central bankallowed the bhat to float.

The bhat fell dramatically (see Exhibit 9.2) andsoon other Asian currencies (Philippine peso,Malaysian ringgit and the Indonesian rupiah)came under speculative attack.

E hibi 9 2 Th Th i B h d h


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Exhibit 9.2 The Thai Baht and theAsian Crisis


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Sirivat Sandwich


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The Asian economic crisis (which was muchmore than just a currency collapse) hadmany roots besides traditional balance ofpayments difficulties:

Corporate socialism

Corporate governance

Banking liquidity and management

What started as a currency crisis became aregion-wide recession.


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June 1967: The old Sterling-

linked Malayan/Straits Dollar

was replaced by separate

dollars of Malaysia (RM),

Singapore and Brunei.

February 1973: Following the

U.S. Dollar devaluation, the

RM was realigned to

M$2.5376 per U.S. dollar,

based on the currency's

unchanged gold content.

June 1973: Malaysia placed

the Effective rate for her

dollar on a controlled, floating

basis. Bank Negara Malaysia

intervened in order tomaintain relative stability in

the value of Ringgit in relation

to the basket of currencies.

2 September 1998: The exchange rate was no

longer determined by demand and supply. The

Central Bank announced that the exchange rate of

the Ringgit would be pegged against the U.S.

Dollar at RM3.80 = $1.

In July 2005, the Ringgit no longer pegged to the

US dollar, but shifted to a managed float system.

Malaysia Exchange Rates

(RM/$US)

ll i C


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Illustrative Case:The Russian Crisis of 1998

Debt service had become a real problem Capital flight was taking place

The ruble traded via a managed float that hadbeen continually adjusted since 1996

August 7, 1998 began the August Crash with theannouncement that currency reserves had fallen$800M in the last week

August 10, the Russian stock market falls 5%

August 17, Russia announces the ruble will beallowed to devalue by 34%

Exhibit 9.3 illustrates the rubles decline

E hibit 9 3 Th F ll f th R i


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Exhibit 9.3 The Fall of the RussianRuble


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Technical Analysis


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Forecasting in Practice

Technical analysts, traditionally referred to as chartists, focuson price and volume data to determine past trends that areexpected to continue into the future. really just studies supply and demand in a market

attempts to understand the emotions in the market by studying themarket itself.

The single most important element of technical analysis is thatfuture exchange rates are based on the current exchangerate.

Exchange rate movements can be subdivided into threeperiods:

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, themore inaccurate the forecast is likely to be.

Whereas forecasting for the long run mustdepend on the economic fundamentals of

exchange rate determination, many of theforecast needs of the firm are short to mediumterm in their time horizon and can be addressedwith less theoretical approaches.

Exhibit 9.5 summarizes the various forecastingperiods, regimes, and the authors suggestedmethodologies.

Exhibit 9 5 Exchange Rate


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Exhibit 9.5 Exchange RateForecasting in Practice


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Forecasting: What to Think?

It appears, from decades of theoretical andempirical studies, that exchange rates doadhere to the fundamental principles andtheories previously outlined.

Fundamentals do apply in the long term

There is, therefore, something of afundamental equilibrium pathfor a

currencys value.


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Forecasting: What to Think?

It also seems that in the short term, a variety ofrandom events, institutional frictions, and technicalfactors may cause currency values to deviatesignificantly from their long-term fundamentalpath.

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 withsome regularity and relative longevity.

Exhibit 9.6 illustrates the synthesis of forecastingthought.

Exhibit 9.7 shows the dynamics of exchange ratemanipulation.

Exhibit 9 6 Short Term Noise


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Exhibit 9.6 Short-Term NoiseVersus Long-Term Trends

Exhibit 9 7 Exchange Rate


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Exhibit 9.7 Exchange RateDynamics: Overshooting

What Determines the Exchange Rate: Economic


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gFactors or Market Sentiment?Gregory P. Hopperhttp://wps.aw.com/wps/media/objects/744/761963/rdg39.pdf

ECW2721 Lecture W8 Forex

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