Foreign Exchange Rate Determination Chapter 5 Foreign Exchange Rate Determination

Foreign Exchange Rate Determination Exchange rate determination is complex. The following exhibit 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 of payments approach, asset market approach), and secondly by the individual drivers within those approaches. These are not competing theories but rather complementary theories. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Foreign Exchange Rate Determination Without the depth and breadth of the various approaches combined, our ability to capture the complexity of the global market for currencies is lost. In addition to gaining an understanding of the basic theories, it is equally important to gain a working knowledge of: the complexities of international political economy; societal and economic infrastructures; and, random political, economic, or social events affect the exchange rate markets. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Exhibit 5.1 The Determinants of Foreign Exchange Rates Parity Conditions 1. Relative inflation rates 2. Relative interest rates 3. Forward exchange rates 4. Interest rate parity Spot Exchange Rate Is there a sound and secure banking system in-place to support currency trading activities? Is there a well-developed and liquid money and capital market in that currency? 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 Balance of Payments 1. Current account balances 2. Portfolio investment 3. Foreign direct investment 4. Exchange rate regimes 5. Official monetary reserves Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Exchange Rate Determination: The Theoretical Thread The previous exhibit, with its tripartite categorization of exchange rate theory is a good start but – in our humble opinion – is not robust enough to capture the multitude of theories and approaches. Therefore, in the following slides, we will introduce several additional streams of thought. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Exchange Rate Determination: The Theoretical Thread The theory of purchasing power parity is the most widely accepted theory of all exchange rate determination theories: PPP is the oldest and most widely followed of the exchange rate theories. Most exchange rate determination theories have PPP elements embedded within their frameworks. PPP calculations and forecasts are however plagued with structural differences across countries and significant data challenges in estimation. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Exchange Rate Determination: The Theoretical Thread The balance of payments approach is the second most utilized theoretical approach in exchange rate determination: The basic approach argues that the equilibrium exchange rate is found currency flows match up vis a vis current and financial account activities. This framework has wide appeal as BOP transaction data is readily available and widely reported. Critics may argue that this theory does not take into account stocks of money or financial assets. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Exchange Rate Determination: The Theoretical Thread The monetary approach in its simplest form 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. 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. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Exchange Rate Determination: The Theoretical Thread The asset market approach argues that exchange rates are determined by the supply and demand for a wide variety of financial assets: Shifts in the supply and demand for financial assets alter exchange rates. Changes in monetary and fiscal policy alter expected returns and perceived relative risks of financial assets, which in turn alter exchange rates. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Exchange Rate Determination: The Theoretical Thread 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. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

The Asset Market Approach to Forecasting The asset market approach assumes that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations or drivers (among others): Relative real interest rates Prospects for economic growth Capital market liquidity A country’s economic and social infrastructure Political safety Corporate governance practices Contagion (spread of a crisis within a region) Speculation Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

The Asset Market Approach to Forecasting 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 asset market approach is also applicable to emerging markets, however in these cases a number of additional variables contribute to exchange rate determination (previous slide). Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Disequilibrium: Exchange Rates in Emerging Markets Although the three different schools of thought on exchange rate determination (parity conditions, balance of payments approach, asset approach) make understanding exchange rates appear to be straightforward, that it rarely the case. 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. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Illustrative Case: The Asian Crisis 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 1997. 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. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Illustrative Case: The Asian Crisis The Thai government intervened directly (using up precious hard currency reserves) 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. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Illustrative Case: The Asian Crisis 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. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Exhibit 5.3 Comparative Daily Exchange Rates: Relative to the US$ 120 110 100 90 80 INSERT EXHIBIT 5.3 70 60 50 40 Philippine Peso 30 Thai Baht Malaysian Ringgit 20 Indonesian Rupiah 10 Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 97 97 97 97 97 97 97 97 97 98 98 98 98 98 98 98 98 98

Illustrative Case: The Russian Crisis 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. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Illustrative Case: The Russian Crisis 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. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Illustrative Case: The Russian Crisis 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. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Exhibit 5.4 Daily Exchange Rates: Russian Rubles per US$ 27.5 25.0 22.5 20.0 17.5 15.0 12.5 10.0 7.5 5.0 Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May 98 98 98 98 98 98 98 99 99 99 99 99 Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Illustrative Case: The Argentine Crisis 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 nation’s standard of living in the past. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Illustrative Case: The Argentine Crisis 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 Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Illustrative Case: The Argentine Crisis 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. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Exhibit 5.7 The Collapse of the Argentine Peso 3.75 3.50 3.25 3.00 2.75 2.50 2.25 2.00 1.75 1.50 1.25 1.00 0.75 2 6 2 9 1 6 2 3 30 8 1 3 2 2 7 8 1 3 2 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Jan 2002 Feb 2002 Mar 2002

Forecasting in Practice 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. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Forecasting in Practice 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 Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Forecasting in Practice 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. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Exhibit 5.10 Differentiating Short-Term Noise from Long-Term Trends Foreign currency per unit of domestic currency Fundamental Equilibrium Path Technical or random events may drive the exchange rate from the long-term path Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Time

Exhibit 5.11 Exchange Rate Dynamics: Overshooting Spot Exchange Rate , $/ S 1 Overshooting S 2 S t t 1 2 Time Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Mini-Case Questions: JP Morgan Chase’s Forecasting Accuracy? 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 JPMC’s spot rate forecasts? Copyright © 2007 Pearson Addison-Wesley. All rights reserved.