Foreign Exchange Rate Determination (or chapter 5). Agenda. How BOP explains exchange rates? Asset market approach to exchange rates. Forecasting in practice. How different theories combine to explain recent currency crises?. Exchange Rate Determination. Basic approaches Parity conditions
(or chapter 5)
Capital Account Balance
Financial Account Balance
Balance of Payments
X exports, M imports
CI capital inflows, CO capital outflows
FI financial inflows, FO financial outflows
FXB official monetary reservesFlow (BOP) Approach
imperfect capital substitutability
perfect capital substitutability
Risk premium = 0
Interest rate parity
Note: risk premium =/= 0
Forward rate biased predictor
sticky commodity prices
supply of home country bonds
supply of foreign country bonds
domestic interest rates
foreign interest rate
expected rate of home currency
home country current account
habitatThe Portfolio-Balance Approach
Effects of Macroeconomic Shocks on forex
3 general types of forecasts:
Forecast Period Regime Recommended Methods to Forecast…
SHORT-RUNFixed Rate1. Assume fixed rate.
2. Capital controls, black market rates?
3. Official reserves?
LONG-RUNFixed Rate 1. BOP: trade surpluses?
2. Domestic inflation?
3. Hard currency reserves?
SHORT-RUNFloating Rate 1. Forward rates?
3. Government interventions & news releases?
LONG-RUNFloating Rate 1. PPP & inflation.
2. Economic growth.
3. Technical analysis long-term trends; “waves”
Thailand’s Deteriorating Balance of Payments, 1991-1998Excess capital inflows, 1996 & 1997
Source: International Financial Statistics, IMF
$ 1,060,000 Repay
$ 1,160,000 Earn
$ 60,000 Profit
U S dollar money market
S =B 25.00/$
S360 = B 25.00/$
Thai baht money market
Invest at 12.00% per annum
Thai Interest/Exch. Rate Disequilibria