august 8, 2015foreign exchange determination1 forecasting exchange rates foreign exchange...

April 19, 2023 Foreign Exchange Determination 1

Forecasting exchange rates

Foreign Exchange Determination


Forecasting (fundamental analysis) fundamental analysis

Theoretical analysis Purchasing power parity

balance of payments Cash flow analysis

monetary & fiscal policies Stock analysis

regulatory policies Trade policies

political risk

Theoretical analysis

Purchasing power parity Assuming efficient markets

Real world prices converge Measurement problems

Market baskets used to measure inflation are not consistent

Fisher effect Interest rate parity


Parity conditions


ee

i

iT cd

u sd

T

0

1

1

1

1

1

1

i

icd

u sd

T

cd

u sd

T

*

*

*

*

e

eT cd

usd

T

0

1

1

Purchasing Power Parity

Fisher effect

International Fisher effect

f

e

i

iT cd

u sd

T

0

1

1

Interest rate parity

f eT T Unbiased predictor

Parity conditions


For parity to hold efficient market conditions needed

Thick markets many buyers, many sellers

Perfect information Low or no market frictions

Transactions costs Taxes, tariffs

May be most useful pointing to the existence of frictions in the market

Balance of payments


Cash flow analysis Current acct, capital acct, financial acct,

reserve acct Relative demands and supplies of dollars

in the exchange markets Function of real cash flows to pay for

Trade in goods, services, transfers FDI, investment in real assets Portfolio investment, investment in financial

assets

Monetary


Changes in supply and demand for money BOP tracks the foreign exchange as a

medium of exchange (flow) Store of wealth (stock)

Demand for dollars to hold Moderates BOP influences

China holding dollar assets Other currencies are substitutes

Moving from dollar reserves to euro reserves


Central Bank affects on liquidity cash & currency

directly supplied by CB

checking accounts & debit cards money multiplier determined CB directly affects the multiplier

reserve requirements capital requirements

credit cards availability of credit indirectly affected by CB


Factors affecting money & exchange rates economic growth

economic growth increases demand for base inflation

CB controls the supply of base money interest rates

CB controls the bank rate directly CB influences term structure of interest rates

indirectly political risk


Economic Growth Growth increases the demand for money

demand for money curve shifts up

Assume CB keeps money supply constant no change in the vertical supply curve

the value of money increases prices and value of money inversely related domestically - deflation internationally - exchange rate appreciation


Money Supply Central Bank increases supply of money

supply curve shifts out

Assuming no change in demand for money the demand for money curve remains stationary

the value of money decreases prices and value of money inversely related domestically - inflation internationally - exchange rate depreciation

Asset market


Bonds, stocks, currencies are close substitutes Changes in demand for financial assets

(other than money) Portfolio diversification

South American investors Saudia Arabian investors

Capital flight Seeking efficient markets

Properly priced financial assets


Term Structure of Interest Rates

Term to maturity

iT

New term structure of interest rates afterCB increases bank rate


Shift in Term Structure of Interest Rates Central bank changes the bank rate

only rate directly controlled by CB least risky rate in the economy

no default risk little interest rate risk - overnight funds rate

other rates will ratchet up relative to risk default - ability to pay interest rate risk - relative to term to maturity


Jump Shift in Term Structure

Term to maturity

iT Jump in term structure after a large changein political risk


Jump Shift in Term Structure Small change in power structure

new rules some increase in uncertainty about future small discrete change in market risk premium

Large change in power structure systemic change in the economy large increase in uncertainty about future large discrete change in market risk premium


Political risk (anticipated) Fiscal policies

taxes, expenditures deficit and debt policies

Monetary policies relative inflation, interest rates exchange rate (foreign reserves, intervention

Regulatory policies trade restrictions capital controls


Political risk (unanticipated) Political risk

probability of change in government probability of change in direction external threats

crime war

Differences between markets official markets unofficial markets (grey & black markets)


Technical Analysis

technical analysis Time series analysis

trends correlation


Political Risk party in power makes the rules

distribution of income and wealth tax law transfers

regulatory environment increase or decrease frims’ costs of doing

business

change of party in power change in the rules

for example PQ in power in Québec


Capital Asset Pricing System

i i i ii r f i M rf ( )

iM the market rate increases as the market becomes more risky

iM - irf the market risk premium also increases

I measure of risk increases with market volatility


gold silver cd denominated t-

bills foreign currency

denominated t-bills

cash currency chartered bank

reserves held at the Bank of Canada

Bof C buys US dollars as an asset

Canadian dollar liability increases

Unsterilized Intervention


Domestic Affects of an Unsterilzed Intervention

Base money increases by amount of purchase

pressure exerted on prices to increase inflation in the economy Canadian goods cost more in cd


Foreign Affects of anUnsterlized Intervention short run

exchange rate is not allowed to adjust

long run higher Canadian inflation

US goods cost relatively less to Canadians Canadian goods cost relatively more to US

consumers exchange rate remains relatively

constant


gold silver cd denominated t-

bills foreign currency

denominated t-bills

cash currency chartered bank

reserves held at the Bank of Canada

B of C sells equal value in other assets

Bof C buys US dollars as an asset No increase in

B of C liabilities

Sterlized Intervention


Domestic Affects of an Sterilzed Intervention

Base money remains constant

prices remain constant


Foreign Affects of anSterlized Intervention

short run exchange rate is not allowed to adjust

long run pressure remains on exchange rate to

depreciate BOT deficit remains eventually the cd price of the usd will

increase


BOT (Current Account) Deficit currency depreciation

higher prices for imports lower prices for exports

protectionism tariffs, quotas, import restrictions

capital controls restrict foreign ownership

exchange market intervention


Covered Interest Arbitrage Borrow 100,000 cd @ 6.75% Buy 66,339.39 usd spot at 1.5074 Lend 66,339.39 for one year @ 7.75% Buy 107,585.59 cd forward @ 1.5051 collect loan of 71,480.69 usd take delivery of forward contract pay off loan of 106,750 cd riskless return of 835.59 cd

august 8, 2015foreign exchange determination1 forecasting exchange rates foreign exchange...

Documents

money demand

money curve

cb slide

money bop

supply of base money

money supply constant

market slide

parity conditions