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1 Foreign Exchange Rate Determination (or chapter 5)

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Presentation on theme: "1 Foreign Exchange Rate Determination (or chapter 5)"— Presentation transcript:

1 1 Foreign Exchange Rate Determination (or chapter 5)

2 2 Agenda How BOP explains exchange rates? Asset market approach to exchange rates. Forecasting in practice. How different theories combine to explain recent currency crises?

3 3 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.

4 4 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

5 5 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

6 6 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.

7 7 Note: risk premium =/= 0 Forward rate biased predictor Preferred Local Habitat Model Uniform Preference Model Portfolio-Balance Approach imperfect capital substitutability Monetary Approach perfect capital substitutability Risk premium = 0 Interest rate parity Monetarist Model Overshooting Model completely flexible commodity prices sticky commodity prices Asset Model Approach

8 8 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.

9 9 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).

10 10 The Portfolio-Balance Approach Effects of Macroeconomic Shocks on forex supply of home country bonds supply of foreign country bonds domestic interest rates foreign interest rate expected rate of home currency depreciation home wealth home country current account surplus + depreciates - appreciates + depreciates - appreciates Increase in: Impact on home currency all preferred local habitat Model

11 11 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.

12 12 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). S t = E[S t+1 ].  PPP can be interpreted as market’s consensus forecast of future exchange rates if markets efficient F t,1 = E[S t+1 | I t ].

13 13 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.

14 14 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.

15 15 Example of Technical Analysis Source:

16 16 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.

17 17 SHORT-RUNFixed Rate1. Assume fixed rate. 2. Capital controls, black market rates? 3. Official reserves? SHORT-RUNFloating Rate1. Forward rates? 2. Inflation? 3. Government interventions & news releases? Forecast PeriodRegimeRecommended Methods to Forecast… LONG-RUNFixed Rate1. BOP: trade surpluses? 2. Domestic inflation? 3. Hard currency reserves? Forecast PeriodRegimeRecommended Methods to Forecast… LONG-RUNFloating Rate1. PPP & inflation. 2. Economic growth. 3. Technical analysis long-term trends; “waves”

18 18 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.

19 19 Asian Crisis Thailand’s Deteriorating Balance of Payments, 1991-1998 Excess capital inflows, 1996 & 1997 Source: International Financial Statistics, IMF

20 20 360 days S =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 StartEnd Thai baht money market B 28,000,000  1.12 Invest at 12.00% per annum Thai Interest/Exch. Rate Disequilibria S 360 = B 25.00/$ $ 1,160,000 Earn $ 60,000 Profit Continuing Uncovered Interest Arbitrage

21 21 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.

22 22 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.

23 23 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?

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