Chapter 3: FX rate determination

1. Chapter 3: FX rate determination • No general “all-explaining” theory exists • Long run • Parity conditions • Short run • Forward rates • Technical analysis • Fundamental analysis into inflationary concerns, etc.

2. The BOP Approach • Balance of Payments = Current Account (Exports - imports) + Capital Account (Transactions related to fixed assets) + Financial Account (Flows related to financial investments) + Reserve Balance

3. The BOP is supposed to balance • e.g. typically, a current account surplus (exports>imports) is countered by a capital/financial account deficit (capital/financial outflows>inflows) • Under a fixed exchange rate system: • monetary authorities are in charge of balancing the BOP • Example: • Elbonian exports > imports • foreigners demand E$ to pay for the exports • shortage of E$ due to low imports • demand for E$ > supply

4. Elbonian gov’t must react to the Current Account imbalance • intervention: selling domestic currency for foreign currencies • If Current Account deficits are persistent, risk of running out of reserves • devaluation? • So, under fixed exchange rates, BOP can indicate pressure on the currency • Under managed float, interest rates often used to induce financial flows • disadvantage: high interest rates hurt the domestic economy • Why is BOP less of a forecasting tool under floating rates?

5. International parity conditions • Theoretical macro-economic relationships affecting the exchange rates • prices or price changes • interest rates • forward exchange rates

6. Arbitrage • Arbitrage = the profit is known with certainty - no risk • In contrast, in speculation trading is done with an expectation that a profit will be earned - risky

7. What happens when someone finds an arbitrage opportunity? • They execute as many transactions as possible • Prices are affected through supply and demand and the arbitrage opportunity disappears. • Arbitrage is a strong market force • Note: In practice, market imperfections may cause the FX markets not to conform to the parity conditions • Reliability of a parity condition depends on its “arbitrageability”

8. Purchasing Power Parity (PPP) • Relationship between the FX rate between two countries and the corresponding price levels. • Based on the notion that goods and services should cost the same in different countries.

9. Law of One Price • No arbitrage condition • The domestic price and the foreign price of a good are equal when converted to the same currency: P$ x S¥/$ = P¥ • Or: S¥/$ = P¥/P$ • A.k.a. Absolute PPP - spot exchange rate is determined by the relative prices of similar baskets of goods • a unit of home currency has the same purchasing power around the world

10. Example: a car in Finland vs. US • According to the Law of one price, P€ = S€/$ x P$ • So, S = price of the car in Finland / price of the car in U.S • This is absolute PPP using just one good • what if this does not hold? • S = 56,000/36,469 = 1.5356 €/$

11. Relative PPP • Any change in the differential rate of inflation between two countries is offset by an equal but opposite change in the spot rate • Currencies with high inflation should depreciate relative to currencies with low inflation • Often measured in terms of changes in the value of a basket of goods

12. Example: • suppose Mexico has 10% inflation • Peru has an inflation rate of 5% • After one year, one Mexican peso would buy less than one unit of Peruvian new sol • We would expect the value of peso to decline relative to the new sol

13. Does PPP hold in the real world? • The relationship can be easily tested with a regression model • In academic studies, PPP has not received much support • The only empirical merit for PPP is in long term forecasting

14. Why might PPP not work? • Arbitrage only works for tradeable goods • Are Big Macs tradeable? • How about services? • Barriers to trade • transportation costs • many goods are not perfect substitutes • cross-country differences in tastes and preferences • imperfect exchange rate pass through (see Exhibit 3.7, p. 73)

15. International Fisher Effect (IFE) • Recall “domestic Fisher effect” • IFE - when interest rate difference between two countries changes  the spot exchange rate changes to offset the interest rate change • Suggests that currencies with high interest rates will depreciate (because high interest rates reflect high expected inflation)

16. IFE parity condition • expect $/¥ to decrease • ¥ depreciates, why? • What is the real gain from higher ¥ interest if IFE holds?

17. The expected change in the spot rate an be estimated by i$ - i¥ = .03 - .06 = -.03  expect ¥ to depreciate by about 3% wrt $ • Relies on assumption that real interest rates across countries are the same • IFE is based on PPP, and therefore does not often hold in practice.

18. Covered Interest Arbitrage • riskless activity in the FX market that equalizes the yield on a domestic financial asset with that of a like foreign financial asset, where both yields are know with certainty today. • Forces the interest rates and the forward rates to be in alignment between two countries

19. Example: • i$ = 5%; i£ = 8% • S = $1.50/£; F = $1.48/£ • You can borrow up to $1,000,000 or £666,667 • Borrow $1,000,000 • Buy £ at spot rate = $1,000,000/1.50 = £666,667 • Invest £666,667 (In a year, it will grow to 666,667(1.08) = £720,000 ) • Sell £720,000 forward at fwd rate = £720,000 (1.48) = $1,065,600 • In a year, pay off the $ loan = $1,000,000 (1.05) = $1,050,000 • Riskless profit of $15,600

20. Interest rate parity (IRP) • the forward rate differs from the spot rate by a sufficient amount to offset the interest rate differential between two currencies • IRP equation: Ftd/f/S0d/f = [(1+id)/(1+if)]t • Or: fwd premium = [(1+id)/(1+if)]t-1

21. Assuming: • direct quotes: HC/FC • foreign and domestic assets are same in terms of risk • If covered interest arbitrage opportunities do not exist, then interest rate parity holds • What if interest rate parity does not hold? • Notice similarity between IFE and IRP - the only difference is using future spot rate rather than forward rate

22. Uncovered interest speculation • Identical to CIA, except uses the future spot rate in place of forward rate • Risky, since the future spot rate is unknown • Higher profit potential since the profits are not locked in either

23. Fwd rate as an unbiased predictor (FRUP) • Forward rate = exchange rate you can “lock in” today for a future transaction • FRUP = “On average, the forward rate predicts the future spot rate correctly” • Test: • Findings: Typically ß1

24. Example: • Spot rate = $1.4606/£ • 3-mo fwd rate = $1.4524/£ • According to FRUH, we would expect the spot rate in 3 months to be $1.4524/£ • Or, at least the forward rate is predicting $ appreciation • What happened?

25. Parity conditions in equilibrium • In equilibrium, the parity conditions are related to each other • See exhibit 3.3, p. 65 • They connect: • Forward premium • Expected spot rate change • Expected inflation difference • Interest rate differential

26. The Asset market approach • “Expectations about economic, political, and social factors determine fx rates” • What makes investors decide to hold a currency? • A currency that is expected to gain value is a better investment • According to the asset market approach, the value change is forecasted • The BOP describes the past; why should it affect the value of the currency today?

27. A stable currency will attract investors • Expectation of stability leads investors to view the currency as a good “vehicle” to store value in • the consequent demand for assets denominated in the currency will further strengthen it • Why does the U.S. dollar often gain value at times of international uncertainty? • What has been different since Sept, 2001?

28. Forecasting FX rates • Why? • Changes in FX rates affect our cash flows. • A/R and A/P • price competitiveness of our products • exports • imports • investment analysis of capital projects • portfolio investment • What is different about these different motives?

29. What if FX markets are efficient? • Weak-form efficiency • today's exchange rate reflects all information about the past exchange rate movements • Semi-strong-form efficiency • all relevant public information is reflected in today's exchange rate • Strong-form efficiency • all relevant public and private information is reflected in today's exchange rate

30. If FX markets are efficient, forecasting is likely a waste of time and money • Empirical evidence does tend to support efficiency • But, . . . • the stakes can be high • is gov't intervention predictable? • some markets are segmented • many nations use fixed exchange rates

31. Uses of Forex forecasts • For speculators • For MNCs • Strategic planning • Budgeting • Current asset/liability management • To hedge or not to hedge? • Approaches: • In house vs. commercial forecasts • Form: point estimate / interval estimate / direction of movement

32. Long-term vs. short-term • Short-term forecasting is more of a concern for companies making hedging decisions on their existing assets/liabilities • Requires accuracy • Long-term forecasting is needed when making capital investment decisions • What is the yen going to be worth in 10 years??? • While it is next to impossible to accurately predict exchange rates, forecasting the direction of change may be adequate

33. Forecasting methods • In a simplified world: • Using international parity conditions • Works better for long-run forecasts • In the real world: • Under fixed vs. floating regimes • Floating: economic forces; market psychology (?) • Fixed: economic forces; political behavior • Fundamental Analysis • Technical Analysis • Market Based Analysis • Combination of all of the above

34. Choice of methods • Depends on the rate system • Under the fixed system, the focus is on predicting political actions • Under floating rates, focus on the market forces expected to affect the rate • Depends on the time span • In short term, the fixed rate will only change upon “extreme political events” • Short-term floating rates are challenging to predict • In long-term, the fundamental analysis can predict trends

35. Fundamental analysis • Using the economic fundamentals to predict fx rates • Parity conditions, BOP, asset market approach • Problems with fundamental analysis: • Numerous fundamental factors affect exchange rates, their composition and relative importance varies over time • Some factors cannot be directly measured • Some factors have instantaneous impact

36. Technical Analysis • Forecasting future movements and trends in exchange rates, based on their past performance • Assumes that weak-form efficiency does not hold • Problems: • Focus on short term movements • No model with consistent performance exists (as far as we know) • Does not typically give the magnitude of the expected change

37. Evaluation of Forecast Performance • How do we measure accuracy? • Closest to the realized spot rate? • Measuring absolute forecast error • Or on the correct side of the present forward rate? • Determining whether there is a consistent bias in forecasts • Accuracy vs. Correctness