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Copyright © 2007 Pearson Addison-Wesley. All rights reserved. FOREIGN EXCHANGE RATE THEORIES Four theories Purchasing Power Parity Interest Rate Parity.

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Presentation on theme: "Copyright © 2007 Pearson Addison-Wesley. All rights reserved. FOREIGN EXCHANGE RATE THEORIES Four theories Purchasing Power Parity Interest Rate Parity."— Presentation transcript:

1 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. FOREIGN EXCHANGE RATE THEORIES Four theories Purchasing Power Parity Interest Rate Parity Fisher condition for capital market equilibrium Expectations theory of forward rates

2 T HE D ETERMINANTS OF F OREIGN E XCHANGE R ATES 1-2 Parity Conditions 1. Relative inflation rates 2. Relative interest rates 3. Forward exchange rates 4. Interest rate parity Balance of Payments 1. Current account balances 2. Portfolio investment 3. Foreign direct investment 4. Exchange rate regimes 5. Official monetary reserves Asset Approach 1. Relative real interest rates 2. Prospects for economic growth 3. Supply & demand for assets 4. Outlook for political stability 5. Speculation & liquidity 6. Political risks & controls Spot Exchange Rate Is there a well-developed and liquid money and capital market in that currency? Is there a sound and secure banking system in-place to support currency trading activities?

3 INTERNATIONAL PARITY RELATIONSHIP 1-3 To reduce the effect of disparities caused by- Arbitrage, speculation etc This economic behaviour- law of one price Four theories come into practice

4 E XCHANGE RATE DETERMINATION THEORIES 1.Interest rate parity : Relationship between interest rates and Exchange rates of two countries 1-4

5 Exchange rate of two countries will be affected by their interest rate differential Currency of a high interest rate country will be at a forward discount- Relative to the currency of a low interest rate country 1-5

6 Exchange rate(forward& spot) differential will be equal to the interest rate differential between two countries Interest differential=exchange rate(F&S)differential 1+rf = f F/D 1+rd s F/D 1-6

7 rf = Interest rate of country F rd= Interest rate of country D sF/D = Spot exchange rate of country F&D fF/d= Forward rate between country F&D Note : High interest rate:-Forward discount Low interest rate :- Forward premium 1-7

8 Concept:- Interest rate parity works fairly well - internal markets There is no restriction from one country to other Euro currency market are the international capital market – minimum restrictions and control Here the market forces determine interest rates 1-8

9 2. Theory of Purchasing Power Parity: The oldest, and most widely accepted theory Concept: Exchange rate between the currencies of two countries equals the ratio between the prices of goods in these countries 1-9

10 Purchasing power states – The exchange rate between the currencies of two countries will adjust Purpose : To reflect changes in the inflation rates of the two countries Inflation rate differential= current spot & expected spot rate differential 1-10

11 1+iF = E(SF/D) 1+iD sF/D iD= Rate of inflation in country D iF= Rate of inflation in country F sF/D= Spot exchange rate between country F&D E(SF/D)=Expected spot rate between country F&D in future 1-11

12 3. Expectation theory of forward rates: Expected future spot rate depends on the expectations of the FOREX market participants Concept: When the forward rate is higher than the market participants prediction- 1-12

13 Participants will tend to sell the foreign currency forward Cause a fall in the forward rate Until it equals the expected future spot rate 1-13

14 Forward rate& the current rate differential must be equal to the expected spot rate & the current spot rate differential F&C spot rate differential=Expected & Current spot rate differential 1-14

15 fF/D = E(Sf/d) sF/D s F/D E( Sf /D)=Expected future spot exchange rate for a unit of foreign currency per unit of domestic currency f F/D =forward rate between countries F&D 1-15

16 4.International Fisher Effect: Nominal interest rate comprises of a real interest rate and an expected rate of inflation Nominal interest rate adjust when the inflation rate is expected to change Concept: 1-16

17 Nominal interest rate will be higher :–When a higher inflation rate is expected It will be lower when a lower inflation rate is expected 1+nominal interest rate=(1+real interest rate)(1+inflation rate) 1+rn =(1+rr)(1+i) 1-17

18 rn= rr+i+rri rn= Nominal rate of interest rr= Real rate of interest i= Inflation rate 1-18

19 International Fischer Effect – Nominal interest rate differential must equal to the expected inflation rate differential in two countries Nominal interest rate differential=expected inflation rate differential 1-19

20 1+rf = E(1+if) 1+rn E(1+if) 1-20

21 EXCHANGE RATE MECHANISM There is a price for any purchase or sale of a currency Such a price in the exchange market is called the exchange rate Definition: The no.of units of one currency that will be exchanged for a unit of another currency 1-21

22 E XCHANGE RATE OF ANY CURRENCY CAN BE EXPRESSED IN TWO WAYS 1.In terms of foreign currency units against a given unit of domestic currency Eg Rs.45=$1 2.In terms of the no.of domestic currency units against a given unit of foreign currency Eg:$1=Rs

23 Exchange rate depends on the supply and demand for a currency Supply and demand depends on : Arbitrage and interest rate speculation, Currency speculation and Short-term capital flows 1-23

24 GUSTAV S THEORY Prof. Gustav Cassel-purchasing power parity theory Exchange rates are determined by what each unit of a currency can buy in terms of real goods and services in its own country Rate of exchange is the amount of currency which would buy the equivalent basket of goods and services in both countries 1-24

25 There should be comparison between currencies at two periods of time One year as the basis of comparison But no absolute comparison between two currencies are possible 1-25

26 It is assume that the base year prices in both the countries are at equilibrium Exchange ratio at that time represents ratio of their purchasing powers 1-26

27 E.g.. If base period exchange rate is 1:1 a doubling of prices in the domestic economy of B with AS price remaining constant. These lead to a new exchange rate of 1:2 This ratio would set the bounds or limits to day – to-day fluctuations in the exchange rates 1-27

28 S POT AND FORWARD RATES Importer is paying on receipts of documents He can buy dollars spot and The bank sells him spot dollars If importer agrees to pay at a later date His demand arise only at a later date These dollars are called forward dollars The market is a forward market 1-28

29 Existence of forward market provides cover- Or hedge against fluctuations in the spot exchange rates This exchange risk falls on the bank who are buying or selling dollars forward Banks can pass the risk to central bank Forward purchase or sale of currencies include interest rate fluctuations 1-29

30 Forward currency may be quoted at premium or at discount E.g.: premium(higher than the spot expressed in foreign currency per domestic unit quoted) 2003 Rs. 100=$2.7555, if interest rates abroad are higher than at home 1-30

31 S PECULATION Speculation and hedging are taking place in free market It take advantage of interest rate and exchange rate differentials Speculation on a limited scale is healthy It should be on both sides of purchase and sale NOTE: Not possible in India where banks are allowed only to keep a minimum balance of cash 1-31

32 A RBITRAGE Exchange rate of currencies are same in all the centers For eg. If dollar rate per sterling is different in New York and Frankfurt Then funds would flow in either direction to take advantage of the rate differential 1-32

33 Slight differentials might be still there due to : Carrying costs of moving funds from one place to another Operations in terms of movement of funds from one centre to another Known as arbitrage operations Arbitrage can be three point or multi point E.g.. moving funds from dollar to franc, franc to sterling, sterling to dollar 1-33

34 TYPES OF EXCHANGE RATE 1.Floating Vs. Fixed rates Traditional floating systems are: Single float, joint float, managed float etc Fixed rates come into existence after the break down of Breton woods system in August 1971 Floating rate is the rate which is freely allowed to fluctuate According to the supply and demand situation 1-34

35 If no intervention by central bank it is known as free float Some degree of intervention exists which lead to a managed float Managed float can be either single or joint When various currencies were floating with varying degree of intervention- within a band of 2.25% on either side are single float 1-35

36 The European Common Market countries are under a joint float with in a narrow band called snake in the tunnel ECM-west Germany, France, Belgium, Netherlands, Luxemburg and Ireland, Denmark and Sweden Indian rupee is kept stable still

37 Then rupee devalued and Limited Exchange Management System (LERMS) FERA was diluted Banks are allowed greater freedom of lending Deposit and lending rates are freed Now FERA is changed to FEMA in

38 Q UOTATIONS Now quotations are called direct quotes Principle the banker follows is to give two way quotes-based on give less and take more The spread between the buying and selling rates is the banks profit Spread depends on the cable cost, brokerage cost and administrative cost 1-38

39 E.g.; if the quotation is$1=Rs First is the purchase price Second is the selling price Principle is buy low sell high 1-39

40 M ETHOD OF QUOTATION 1. Direct method: Gives no. of currency units of domestic country to one unit of foreign currency 2.Indirect method: Gives no. of foreign currency units for one unit of domestic currency 1-40

41 E.g. indirect method: For Rs.100= US-2.99 UK-1.21 EURO-1.76 Pakistan Malaysia-8.7 China

42 D IRECT METHOD As on June 30, USD=Rs UKsterling=Rs Euro=Rs ooYen=Rs SOURCE : Official quote of RBI 1-42

43 E XCHANGE RATE CALCULATION Spot TT buying rate 1-43

44 E XCHANGE R ATE D ETERMINATION : T HEORIETICAL APPROACH The balance of payments approach is the most utilized theoretical approach in exchange rate determination: demand and supply of a currency reflected in current and financial accounts determines the exchange rate. This framework has wide appeal as balance of payment transaction data is readily available and widely reported. This theory does not take into account stocks of money or financial assets. 1-44

45 E XCHANGE R ATE D ETERMINATION : T HEORIES The monetary approach states that the exchange rate is determined by the supply and demand for national monetary stocks, as well as the expected future levels and rates of growth of monetary stocks. Changes in money stocks affect the inflation rate, which in turn affects the exchange rates through the PPP effect. Other financial assets, such as bonds are not considered relevant for exchange rate determination, as both domestic and foreign bonds are viewed as perfect substitutes. 1-45

46 E XCHANGE R ATE D ETERMINATION : T HEORIES The asset market approach argues that exchange rates are determined by the supply and demand for a wide variety of financial assets. Changes in monetary and fiscal policy alter expected returns and relative risks of financial assets, which in turn alter exchange rates. Mundell-Fleming proposed this view. 1-46

47 E XCHANGE R ATE D ETERMINATION : T HEORIES The forecasting inadequacies of fundamental theories has led to the growth and popularity of technical analysis, the belief that the study of past price behavior provides insights into future price movements. The primary assumption is that any market driven price (i.e. exchange rates) follows trends. 1-47

48 T HE A SSET M ARKET A PPROACH TO F ORECASTING The asset market approach assumes that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations: 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 1-48

49 T HE A SSET M ARKET A PPROACH TO F ORECASTING : Foreign investors are willing to hold securities and undertake foreign direct investment in highly developed countries based primarily on relative real interest rates and the outlook for economic growth and profitability. The experience of the U.S. is the case in point. U.S. dollar strengthened despite growing current account deficits during the , 1990 and Foreign capitals flowed into U.S. due to rising stock and real estimate prices, low inflation and relatively high real returns, low political risk 1-49

50 However, the 9/11 attack caused a negative assessment of long-term prospect for growth and profitability, and political risk in the U.S. Loss of confidence in the U.S. economy led to a large outflow of foreign capital and subsequently depreciation of U.S. dollar by 18% between Jan- July

51 3. D ISEQUILIBRIUM : EXCHANGE RATES IN EMERGING MARKETS The asset market approach is also applicable to emerging markets, however in these cases a number of additional variables contribute to exchange rate determination. The large and liquid capital and currency markets follow many of 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 the assumptions underlying the theory. 1-51

52 I LLUSTRATIVE C ASE : T HE A SIAN C RISIS The roots of the Asian currency crisis extended from a fundamental change in the economics of the region, the transition of many Asian nations from being net exporters to net importers. The most visible roots of the crisis were the excess capital inflows into Thailand in 1996 and early As the investment bubble expanded, some market participants questioned the ability of the economy to repay the rising amount of debt and the Thai bhat came under attack. 1-52

53 I LLUSTRATIVE C ASE : T HE A SIAN C RISIS The Thai government intervened directly in the fx market and indirectly by raising interest rates in support of the currency. Soon thereafter, the Thai investment markets ground to a halt and the Thai central bank allowed the bhat to float. The bhat fell dramatically and soon other Asian currencies (Philippine peso, Malaysian ringgit and the Indonesian rupiah) came under speculative attack. 1-53

54 I LLUSTRATIVE C ASE : T HE A SIAN C RISIS The Asian economic crisis (which was much more than just a currency collapse) had many roots besides traditional balance of payments difficulties: Corporate socialism Corporate governance Banking liquidity and management What started as a currency crisis became a region-wide recession. 1-54

55 E XHIBIT 5.3 C OMPARATIVE D AILY E XCHANGE R ATES : R ELATIVE TO THE US$ 1-55 INSERT EXHIBIT 5.3 Apr 97 Sep 97 Jan 98 Mar 98 May 98 Jul 98 Jun 97 Aug 97 Nov 97 May 97 Oct 97 Jul 97 Dec 97 Feb 98 Apr 98 Jun 98 Aug 98 Sep Philippine Peso Thai Baht Malaysian Ringgit Indonesian Rupiah

56 I LLUSTRATIVE C ASE : T HE R USSIAN C RISIS OF 1998 The crisis of August 1998 was the culmination of a continuing deterioration in general economic conditions in Russia. From 1995 to 1998, Russian borrowers (both government and non-governmental) had gone to the international capital markets for large quantities of capital. Servicing this debt soon became an increasing problem, as it was dollar denominated and required dollar denominated debt service. 1-56

57 I LLUSTRATIVE C ASE : T HE R USSIAN C RISIS OF 1998 The Russian current account (while a healthy surplus of $15 - $20 billion per year) was not finding its way into internal investment and external debt service. Capital flight began to accelerate, and hard currency earnings flowed out of the country. As the Russian rouble operated under a managed float, the Central Bank had to intervene in foreign exchange markets to support the currency if it came under pressure. 1-57

58 I LLUSTRATIVE C ASE : T HE R USSIAN C RISIS OF 1998 During the month of August, 1998, the Russian government continued to drain its reserves and had increasing difficulties in raising additional capital in support of its reserves on the international markets. By mid-August, the Russian Central Bank announced it would allow the rouble to fall, postponed short-term domestic debt service and initiated a moratorium on all repayment of foreign debt owed by Russian banks and private borrowers to avert a banking collapse. 1-58

59 E XHIBIT 5.4 D AILY E XCHANGE R ATES : R USSIAN R UBLES PER US$ 1-59 Jun 98 Nov 98 Mar 99 May 99 Aug 98 Oct 98 Jan 99 Jul 98 Dec 98 Sep 98 Feb 99 Apr

60 I LLUSTRATIVE C ASE : T HE A RGENTINE C RISIS OF 2002 In 1991 the Argentine peso had been fixed to the US dollar at a one-to-one rate of exchange. A currency board structure was implemented in an effort eliminate the source inflation that had devastated the nations standard of living in the past. 1-60

61 I LLUSTRATIVE C ASE : T HE A RGENTINE C RISIS OF 2002 By 2001, after three years of recession, three important problems with the Argentine economy became apparent: The Argentine Peso was overvalued The currency board regime had eliminated monetary policy alternatives for macroeconomic policy The Argentine government budget deficit – and deficit spending – was out of control 1-61

62 I LLUSTRATIVE C ASE : T HE A RGENTINE C RISIS OF 2002 In January 2002, the peso was devalued as a result of enormous social pressures resulting from deteriorating economic conditions and substantial runs on banks. However, the economic pain continued and the banking system remained insolvent. Social unrest continued as the economic and political systems within the country collapsed; certain government actions set the stage for a constitutional crisis. 1-62

63 E XHIBIT 5.7 T HE C OLLAPSE OF THE A RGENTINE P ESO Jan 2002Feb 2002Mar 2002

64 4. F ORECASTING IN P RACTICE Technical analysts, traditionally referred to as chartists, focus on price and volume data to determine past trends that are expected to continue into the future. The single most important element of technical analysis is that future exchange rates are based on the current exchange rate. Exchange rate movements can be subdivided into three periods: Day-to-day Short-term (several days to several months) Long-term 1-64

65 F ORECASTING IN P RACTICE Numerous foreign exchange forecasting services exist, many of which are provided by banks and independent consultants. Some multinational firms have their own in- house forecasting capabilities. Predictions can be based on elaborate econometric models, technical analysis of charts and trends, intuition, and a certain measure of gall. The usefulness of the forecasting services depends on the motive for forecasting and the required accuracy of the forecast. 1-65

66 F ORECASTING IN P RACTICE The longer the time horizon of the forecast, the more inaccurate the forecast is likely to be. Whereas forecasting for the long run must depend on the economic fundamentals of exchange rate determination, many of the forecast needs of the firm are short to medium term in their time horizon and can be addressed with less theoretical approaches. 1-66

67 E XHIBIT 5.10 D IFFERENTIATING S HORT -T ERM N OISE FROM L ONG -T ERM T RENDS 1-67 Time Foreign currency per unit of domestic currency Fundamental Equilibrium Path Technical or random events may drive the exchange rate from the long-term path

68 E XHIBIT 5.11 E XCHANGE R ATE D YNAMICS : O VERSHOOTING 1-68 S 0 t 1 t 2 S 1 S 2 Spot Exchange Rate, $/ Overshooting Time

69 M INI -C ASE Q UESTIONS : JP M ORGAN C HASE S F ORECASTING A CCURACY ? How would you actually go about calculating the statistical accuracy of these forecasts? Would Vesi have been better off using the current spot rate as the forecast of the future spot rate, 90 days out? Forecasting the future is obviously a daunting challenge. All things considered, how well do you think JPMC is doing? If you were Vesi, what would you conclude about the relative accuracy of JPMCs spot rate forecasts? 1-69

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