Presentation on theme: "FOREIGN EXCHANGE RATE THEORIES"— Presentation transcript:
1 FOREIGN EXCHANGE RATE THEORIES Four theoriesPurchasing Power ParityInterest Rate ParityFisher condition for capital market equilibriumExpectations theory of forward rates
2 The Determinants of Foreign Exchange Rates Parity Conditions1. Relative inflation rates2. Relative interest rates3. Forward exchange rates4. Interest rate paritySpotExchangeRateIs there a sound and securebanking system in-place to supportcurrency trading activities?Is there a well-developedand liquid money and capitalmarket in that currency?Asset Approach1. Relative real interest rates2. Prospects for economic growth3. Supply & demand for assets4. Outlook for political stability5. Speculation & liquidity6. Political risks & controlsBalance of Payments1. Current account balances2. Portfolio investment3. Foreign direct investment4. Exchange rate regimes5. Official monetary reserves
3 INTERNATIONAL PARITY RELATIONSHIP To reduce the effect of disparities caused by-Arbitrage , speculation etcThis economic behaviour- ‘law of one price’Four theories come into practice
4 Exchange rate determination theories 1.Interest rate parity:Relationship between interest rates andExchange rates of two countries
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
6 Exchange rate(forward& spot) differential will be equal to the interest rate differential between two countriesInterest differential=exchange rate(F&S)differential1+rf = f F/D1+rd s F/D
7 rf = Interest rate of country F rd= Interest rate of country DsF/D = Spot exchange rate of country F&DfF/d= Forward rate between country F&DNote : High interest rate:-Forward discountLow interest rate :- Forward premium
8 Concept:-Interest rate parity works fairly well -internal marketsThere is no restriction from one country to otherEuro currency market are the international capital market –minimum restrictions and controlHere the market forces determine interest rates
9 2. Theory of Purchasing Power Parity:The oldest, and most widely accepted theoryConcept:Exchange rate between the currencies of two countries equals the ratio between the prices of goods in these countries
10 Purchasing power states – The exchange rate between the currencies of two countries will adjustPurpose:To reflect changes in the inflation rates of the two countriesInflation rate differential= current spot & expected spot rate differential
11 1+iF = E(SF/D)1+iD sF/DiD= Rate of inflation in country DiF= Rate of inflation in country FsF/D= Spot exchange rate between country F&DE(SF/D)=Expected spot rate between country F&D in future
12 3. Expectation theory of forward rates: Expected future spot rate depends on the expectations of the FOREX market participantsConcept:When the forward rate is higher than the market participants prediction-
13 Participants will tend to sell the foreign currency forward Cause a fall in the forward rateUntil it equals the expected future spot rate
14 Forward rate& the current rate differential must be equal to the expected spot rate & the current spot rate differentialF&C spot rate differential=Expected & Current spot rate differential
15 fF/D = E(Sf/d)sF/D s F/DE( Sf /D)=Expected future spot exchange rate for a unit of foreign currency per unit of domestic currencyf F/D =forward rate between countries F&D
16 4.International Fisher Effect: Nominal interest rate comprises of a real interest rate and an expected rate of inflationNominal interest rate adjust when the inflation rate is expected to changeConcept:
17 Nominal interest rate will be higher :–When a higher inflation rate is expected It will be lower when a lower inflation rate is expected1+nominal interest rate=(1+real interest rate)(1+inflation rate)1+rn =(1+rr)(1+i)
18 rn= rr+i+rrirn= Nominal rate of interestrr= Real rate of interesti= Inflation rate
19 International Fischer Effect – Nominal interest rate differential must equal to the expected inflation rate differential in two countriesNominal interest rate differential=expected inflation rate differential
21 EXCHANGE RATE MECHANISM There is a price for any purchase or sale of a currencySuch a price in the exchange market is called the exchange rateDefinition:The no.of units of one currency that will be exchanged for a unit of another currency
22 Exchange rate of any currency can be expressed in two ways 1.In terms of foreign currency units against a given unit of domestic currencyEg Rs.45=$12.In terms of the no.of domestic currency units against a given unit of foreign currencyEg:$1=Rs.45
23 Exchange rate depends on the supply and demand for a currency Supply and demand depends on :Arbitrage and interest rate speculation,Currency speculation andShort-term capital flows
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 countryRate of exchange is the amount of currency which would buy the equivalent basket of goods and services in both countries
25 There should be comparison between currencies at two periods of time One year as the basis of comparisonBut no absolute comparison between two currencies are possible
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
27 E.g.. If base period exchange rate is 1:1 a doubling of prices in the domestic economy of B with A’S price remaining constant.These lead to a new exchange rate of 1:2This ratio would set the bounds or limits to day – to-day fluctuations in the exchange rates
28 Spot and forward rates Importer is paying on receipts of documents He can buy dollars spot andThe bank sells him spot dollarsIf importer agrees to pay at a later dateHis demand arise only at a later dateThese dollars are called forward dollarsThe market is a forward market
29 Existence of forward market provides cover- Or hedge against fluctuations in the spot exchange ratesThis exchange risk falls on the bank who are buying or selling dollars forwardBanks can pass the risk to central bankForward purchase or sale of currencies include interest rate fluctuations
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
31 Speculation Speculation and hedging are taking place in free market It take advantage of interest rate andexchange rate differentialsSpeculation on a limited scale is healthyIt should be on both sides of purchase and saleNOTE: Not possible in India where banks are allowed only to keep a minimum balance of cash
32 Arbitrage Exchange rate of currencies are same in all the centers For eg.If dollar rate per sterling is different in New York and FrankfurtThen funds would flow in either direction to take advantage of the rate differential
33 Slight differentials might be still there due to : Carrying costs of moving funds from one place to anotherOperations in terms of movement of funds from one centre to anotherKnown as arbitrage operationsArbitrage can be three point or multi pointE.g.. moving funds from dollar to franc , franc to sterling, sterling to dollar
34 TYPES OF EXCHANGE RATE 1.Floating Vs. Fixed rates Traditional floating systems are:Single float, joint float , managed float etcFixed rates come into existence after the break down of Breton woods system in August 1971Floating rate is the rate which is freely allowed to fluctuateAccording to the supply and demand situation
35 If no intervention by central bank it is known as free float Some degree of intervention exists which lead to a managed floatManaged float can be either single or jointWhen various currencies were floating with varying degree of intervention-within a band of 2.25% on either side are single float
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 SwedenIndian rupee is kept stable still 1991
37 Then rupee devalued and Limited Exchange Management System (LERMS) FERA was dilutedBanks are allowed greater freedom of lendingDeposit and lending rates are freedNow FERA is changed to FEMA in 2000
38 Quotations 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 profitSpread depends on the cable cost , brokerage cost and administrative cost
39 E.g.; if the quotation is$1=Rs.45.750-45.780 First is the purchase priceSecond is the selling pricePrinciple is ‘buy low sell high’
40 Method of quotation 1. Direct method: Gives no . of currency units of domestic country to one unit of foreign currency2.Indirect method:Gives no . of foreign currency units for one unit of domestic currency
41 E.g. indirect method:For Rs.100=US-2.99UK-1.21EURO-1.76Pakistan-136.1Malaysia-8.7China-18.97
42 Direct method As on June 30,2005 1 USD=Rs.43.5150 1UKsterling=Rs1Euro=Rs1ooYen=RsSOURCE : Official quote of RBI
44 Exchange Rate Determination: Theorietical 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.
45 Exchange Rate Determination: Theories 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.
46 Exchange Rate Determination: Theories 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.
47 Exchange Rate Determination: Theories 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.
48 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:Relative real interest ratesProspects for economic growthCapital market liquidityA country’s economic and social infrastructurePolitical safetyCorporate governance practicesContagion (spread of a crisis within a region)Speculation
49 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 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 torising stock and real estimate prices,low inflation and relatively high real returns,low political risk
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 2002.
51 3. Disequilibrium: 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.
52 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 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.
53 Illustrative Case: The Asian Crisis 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.
54 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 socialismCorporate governanceBanking liquidity and managementWhat started as a currency crisis became a region-wide recession.
55 Exhibit 5.3 Comparative Daily Exchange Rates: Relative to the US$ 1201101009080INSERT EXHIBIT 5.370605040Philippine Peso30Thai BahtMalaysian Ringgit20Indonesian Rupiah10AprMayJunJulAugSepOctNovDecJanFebMarAprMayJunJulAugSep979797979797979797989898989898989898
56 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.
57 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.
58 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.
60 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.
61 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 overvaluedThe currency board regime had eliminated monetary policy alternatives for macroeconomic policyThe Argentine government budget deficit – and deficit spending – was out of control
62 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.
63 Exhibit 5.7 The Collapse of the Argentine Peso 3.753.503.253.002.752.502.252.001.751.501.251.000.7526291623308132278132Jan 2002Feb 2002Mar 2002
64 4. 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-dayShort-term (several days to several months)Long-term
65 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.The usefulness of the forecasting services depends on the motive for forecasting and the required accuracy of the forecast.
66 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.
67 Exhibit 5.10 Differentiating Short-Term Noise from Long-Term Trends Foreign currency perunit of domestic currencyFundamentalEquilibriumPathTechnical or random eventsmay drive the exchangerate from the long-term pathTime
69 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?