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Foreign Exchange Rate DeterminationForeign Exchange Rate Determination

(or chapter 5)(or chapter 5)

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Agenda• How BOP explains exchange rates?

• Asset market approach to exchange rates.

• Forecasting in practice.

• How different theories combine to explain recent currency crises?

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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.

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Flow (BOP) Approach

Forex as a medium of exchange.

Capital Account Balance

(CI-CO) +

Current Account Balance

(X-M)+

Financial Account Balance

(FI-FO)+

Reserve Balance

FXB=

Balance of Payments

BOP

X exports, M imports

CI capital inflows, CO capital outflows

FI financial inflows, FO financial outflows

FXB official monetary reserves

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BOP Approach Fixed Exchange Rate Countries

• Government bears responsibility to ensure BOP near 0.

• If CA+CAP =/= 0, government must intervene– If government lacks reserves, will have to devalue.

Managed Float Countries• To “defend” currency, may raise interest rates.

• => raises cost of capital for domestic firms

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Stock (Asset Market) Approach Forex as a store of value Willingness to hold monetary claims depends on relative real

interest rates & on country’s 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.

£/$

1£

$£/$1,

£

$£/$

1

1

1

1

ttt SEi

iF

i

iS

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Note: risk premium =/= 0Forward rate biased predictor

Preferred LocalHabitat Model

Uniform PreferenceModel

Portfolio-Balance Approach

imperfect capital substitutability

Monetary Approach

perfect capital substitutabilityRisk premium = 0Interest rate parity

Monetarist Model

Overshooting Model

completely flexiblecommodity prices

sticky commodity prices

Asset Model Approach

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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.

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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).

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The Portfolio-Balance ApproachEffects of Macroeconomic Shocks on forex

supply of home country bondssupply of foreign country bondsdomestic interest ratesforeign interest rateexpected rate of home currencydepreciation

home wealthhome country current account surplus

+ depreciates- appreciates- appreciates+ depreciates+ depreciates

- appreciates- appreciates

Increase in:Impact on

home currency

all

preferredlocal

habitat

Model

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Forecasting Techniques

3 general types of forecasts:

1. Intuitive – expectations should be sufficient efficient market approach

2. Monetary policy fundamental approach.

3. History technical approach.

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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 = E[St+1].

PPP can be interpreted as market’s consensus forecast of future exchange rates if markets efficient Ft,1 = E[St+1| It].

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Fundamental Approach Exceedingly technical. Widely used in banks. Heavy econometrics – 3-step process:

1. Estimate structural model.

2. Estimate future parameter values.

3. Use the model to develop forecasts.

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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 .

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Example of Technical Analysis

Source: http://www.investavenue.com/article.html?ID=5761

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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.

• => Inconsistency.

Stabilizing expectations.

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SHORT-RUN Fixed Rate 1. Assume fixed rate.

2. Capital controls, black market rates?

3. Official reserves?

SHORT-RUN Floating Rate 1. Forward rates?

2. Inflation?

3. Government interventions & news releases?

Forecast Period Regime Recommended Methods to Forecast…

LONG-RUN Fixed Rate 1. BOP: trade surpluses?

2. Domestic inflation?

3. Hard currency reserves?

Forecast Period Regime Recommended Methods to Forecast…

LONG-RUN Floating Rate 1. PPP & inflation.

2. Economic growth.

3. Technical analysis long-term trends; “waves”

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Anatomy of a crisis -- Asia’97 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 country’s 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.

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Asian Crisis

-20

-15

-10

-5

0

5

10

15

20

25

Bil

lion

s of

US

dol

lars

Current Account Capital/Financial Account

Thailand’s Deteriorating Balance of Payments, 1991-1998Excess capital inflows, 1996 & 1997

Source: International Financial Statistics, IMF

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360 daysS =B 25.00/$

B 25,000,000

Investors borrow 6.00% per annum

U S dollar money market

$1,000,000 $ 1,060,000 Repay 1.06

Start End

Thai baht money market

B 28,000,000 1.12

Invest at 12.00% per annum

Thai Interest/Exch. Rate Disequilibria

S360 = B 25.00/$

$ 1,160,000 Earn$ 60,000 Profit

Continuing UncoveredInterest Arbitrage

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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.

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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% ->

41% April 1999, real appreciated against the dollar.

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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?