Foreign exchange rate determination and forecasting
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Foreign Exchange Rate Determination and Forecasting. Outline: I.Balance of Payment II.Parity Conditions Purchasing Power Parity Fisher Effect International Fisher Effect Forward Rate as Unbiased Predictor of Future Spot Rate Interest Rate Parity Covered Interest Arbitrage

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Foreign Exchange Rate Determination and Forecasting

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Foreign Exchange Rate Determination and Forecasting

  • Outline:

  • I.Balance of Payment

  • II.Parity Conditions

  • Purchasing Power Parity

  • Fisher Effect

  • International Fisher Effect

  • Forward Rate as Unbiased Predictor of Future Spot Rate

  • Interest Rate Parity

  • Covered Interest Arbitrage

  • II.Foreign Exchange Rate Forecasting in Practice

  • Methods of Forecasting


I.Description of Balance of Payment Accounting

  • Summarizes economic transaction between residents of one country and the rest of the world. Transactions include

    • Import and Export of goods and services

    • Transfers

    • Capital Flows etc

  • BOP account as an itemization of the factors behind the demand and supply of a currency

  • Rules of Debits and Credits

    • Credits (+): Transactions that represent demands for the local currency in the foreign exchange market. Result from purchases by foreigners of goods, services, financial and real assets, gold and foreign exchange

      • Export of goods and services (sale

      • Receipt of gifts

      • Borrowing (sale of stocks, bonds etc

      • Investment by foreign residents (real estate, expansion of plant and equipment etc

      • Decrease in Official Reserve of gold/foreign currency


I.Description of Balance of Payment Accounting cont’d

  • Debits(-): Transactions that represent supplies of local currency in the foreign exchange market. Result from purchases by residents of goods, services, financial and real assets, gold, or foreign exchange from foreigners.

    • Import of goods and services

    • Gifts and Transfers

    • Lending (purchase of foreign stocks, bonds etc

    • Local investment in foreign countries

    • Increases in Official Reserve of gold/foreign currency

  • Balance of Payment Categories

    • Current Account - flow of goods, services and transfers

    • Capital + Financial Accounts - public and private investments and lending

    • Errors and omissions

    • Official Reserves Account - changes in holdings of gold and foreign currencies


  • I.Description of Balance of Payment Accounting cont’d

    • ACurrent Account Balance (BC)

    • Export of GoodsXX

    • Import of Goods (XX) XX Trade Balance

    • Export of Services XX

    • Import of Services(XX) XX

    • Unilateral Transfers (XX)

    • XX Current Balance

    • BCapital (including Financial) Accounts Balance (BK)

    • Direct InvestmentXX

    • Portfolio InvestmentXX

    • Short term InvestmentsXX XX

    • CErrors and Omissions () XX

    • XX Overall Balance

    • DChanges in Official Reserves (R)XX


    I.Balance of payment Accounting

    • The Balance of Payment Accounting Identity:

    • Assuming no errors and omissions,

    • BC + BK +R = 0

      • Flexible exchange rate system

        • No change in Reserve

          • BC + BK = 0 => BC = - BK

          • correctly measured current account deficit/surplus equals correctly measured capital account surplus/deficit

          • current account deficit/surplus could be caused by capital account surplus/deficit

      • Fixed Exchange Rate System

        • BC + BK +R = 0 ==> R = - (BC + BK)

        • increase/decrease in reserve equals the combined surplus or deficit.

      • Implications of Imbalances in BOP

        • Long term deficits not sustainable


    II.Parity Conditions

    • Assumptions

    • - perfect financial markets (no taxes, no transaction costs, no informational asymmetry, many buyers and sellers)

    • - perfect goods markets (no transaction costs, no barriers to trade, many buyers and sellers)

    • Purchasing Power Parity (PPP)

    • - relates inflation rates to changes in spot rates

    • A. The Law of One Price

    • Identical products trading in different markets should cost the same.

    • - Domestic markets (same currency)

    • - Markets across countries

    • - Prices expressed in common currency should be same

    • e.g. PU.Swheat = S($/£) PUKwheat ==>S($/£) = PU.Swheat / PUKwheat


    II.Parity Conditions cont’d

    • B.PPP (absolute form)

    • If the law of one price holds for all goods and services for similar baskets of goods,

    • PIU.S = S($/£) PIU.K ===> S($/£) = PIU.S / PIUK

    • (i.e Spot exchange rate is determined by relative prices of similar baskets of goods)

    • C.PPP (relative form)

    • If the spot exchange rate between two countries starts in equilibrium, any change in differential inflation rates between them tends to be offset over a long run by an equal but opposite change in the spot exchange rate.

    • Exchange Rate - Direct Quote(# domestic currency/ unit of foreign currency)


    II.Parity Conditions cont’d

    • Exchange Rate - Indirect Quote (# foreign currency/unit of domestic currency)

    • e.g UK inflation rate = 15%; U.S. inflation rate 10%. Hence, if the currencies were in equilibrium at the start of the period, the UK pound should fall by:

    • (0.10 - 0.15)/ 1.15 = - 0.043 or 4.3% or approximately by,

    • 0.10 - 0.15 = -0.05 or 5%

    • Implications of PPP:

    • Real return on an asset should be identical for investors of different countries.

    • Example:

    • Empirical Evidence:

    • 1. Generally PPP not accurate in predicting exchange rate (particularly in the short run)

    • 2. PPP holds well over a long run

    • 3. PPP holds better for countries with relatively high rates of inflation.


    II.Parity Conditions cont’d

    • The Fisher Effect (FE)

    • Relates differentials in nominal interest rates to differentials in inflation rates.

    • Fisher Closed Condition:

    • The nominal interest rates in each country are equal to the required real rate of return to the investor plus premium for expected inflation.

    • Fisher Open Condition (Fisher Effect (Generalized Version)):

    • Differences in nominal interest rates are equal to differences in expected inflation. It asserts that real rates of returns should tend to equalize across countries; hence, nominal rates of interest will vary by the difference in expected inflation.


    II.Parity Conditions cont’d

    • International Fisher Effect (IFE)

    • The spot exchange rate should change in an equal but opposite direction to the difference in nominal interest rates between two countries.

    • Forward Rate as an Unbiased Predictor of the Future Spot Rate

    • i.e. Forward premium on foreign currency equals forecasted change in the spot rate.


    II.Parity Conditions cont’d

    • Interest Rate Parity (IRP)

    • Except for transaction costs, a difference in national interest rate for securities of similar risk and maturity should be equal but opposite sign to the forward exchange rate discount or premium for the foreign currency.

    • Suppose that a U.S. investor is considering to invest $1 in a money market instrument for a year.

    • Alternative 1: Invest in U.S. ($ denominated) money market instrument

    • Return = $1 (1 + i ($))

    • Alternative 2: Invest in foreign money market instrument (say in Japanese Yen)

    • Buy Yen at spot ==> # of yen = 1/S (Assume direct quote ($/Yen)

    • Sell Yen forward (buy dollar forward) at F

    • Return in Yen = 1/S (1 + i (¥))

    • Convert Yen into $ using forward rate F

    • Return = 1/S (1 + i (¥)) F

    • IRP ==> $1 (1 + i ($)) = 1/S (1 + i (¥)) F

    • ==> F/S = (1 + i ($)) / (1 + i (¥))


    II.Parity Conditions cont’d

    • In general (assuming direct quote (# domestic currency/ unit of foreign currency),

    • Covered Interest Arbitrage (CIA)

    • If IRP does not hold, an arbitrageur can earn “riskless” profit by investing in the currency that offers higher return on covered basis.

    • Illustration:

    • Two money market instruments: Dollar money market - i($) = 8% per annum

    • Yen money market - i(¥) = 5% per annum

    • Exchange rates: Spot (S0) = ¥ 135/$

    • Forward rate (180 days) = ¥ 134.5 /$

    • Assume that the arbitrageur can borrow or lend $1,000,000 equivalent in the two markets.


    II.Parity Conditions cont’d

    • Step 1: check if IRP holds:

    • S/F = (1+ id)/(1+ if) = => ¥135/ ¥ 134.5  1.04/1.025

    •  there exists an arbitrage opportunity

    • Step 2: Identify where to invest and where to borrow

    • Method 1: determine implied (i.e. IRP consistent) interest rate of one of the currencies

    • S/F = ¥ 135/ ¥ 134.5 = 1.0037 = (1 + id )/ 1.025 (by IRP)

    • ==> (1 + id ) = 1.0288103 or id = 0.0288/ 6 months Vs 0.04 (actual rate)

    •  cheaper to borrow in Yen market and invest in Dollar market (i.e. Id)

    • Method 2: compare the domestic rate against the effective foreign rate using IRP

    • Recall, from IRP

    • id = 4% Vs if + (s0 - F / F) = 0.025 + (135- 134.5) / 134.5 = 0.0287

    •  cheaper to borrow in Yen market and invest in Dollar market (i.e. Id)


    II.Parity Conditions cont’d

    • Step 3: outline the arbitrage strategy

    • 1. Borrow $1 m equivalent in¥ ($1,000,000 @ ¥ 135 = ¥ 135,000,000)

    • 2. Convert to $ at spot rate of ¥ 135 / $ = $1,000,000

    • Buy forward contract to buy ¥ @ forward rate of ¥ 134.5/$

    • 3. Invest in $ money market instrument for 6 months

    • Total Return: $1,000,000 (1.04) = $1,040,000

    • 4. Repay loan

    • Loan in ¥ = ¥ 135,000,000 (1.025) = ¥ 138,375,000

    • Loan in $ ( @ F) = ¥ 138,375,000/ ¥ 134.5 = $ 1,028,810.40

    • Profit in $(excluding transaction costs) = $1,040,000 - $1,028,810.40=$11,189.60


    III. Foreign Exchange Rate Forecasting

    • Approaches to Forecasting

    • 1.Technical Analysis

    • - Based on trends of data series

    • - used mostly for short term forecasting

    • 2.Fundamental Analysis

    • - based on financial and economic theory

      • The Balance of Payments Approach

        • Analysis of a country’s BOP as indicator of pressure on exchange rate

      • The Asset Market Approach

        • An exchange rate between two currencies represents the price that balances the relative supplies and demands of assets denominated in those currencies .

        • Hence, the relative attractiveness of a currency for investment purposes is a deriving force of exchange rate movements.

  • Example: impact of high economic growth


  • III. Foreign Exchange Rate Forecasting in Practice cont’d

    • Short run forecasts:

    • - for periods less than a year

    • - motivated by a desire to hedge receivables, payables etc

    • - accuracy more important

    • - techniques include: time series techniques fitting trends

    • Forward rate as predictor of future spot rate

    • Long run forecasting

    • - motivated by MNC’s desire to initiate direct foreign investment, raise long term finance etc.

    • - forecast accuracy not critical

    • - recommended techniques include: fundamental analysis, including analysis of balance of payments, relative inflation rates and interest rates.


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