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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

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  • 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
Exchange Rate Determination
  • Basic approaches
    • Parity conditions
    • Flow (BOP) approach
    • Stock (asset market) approach
  • In addition, need to account for important social & economic events, such as:
    • Infrastructure weaknesses,
    • Speculation,
    • Cross-border FDI,
    • Foreign political risks.
flow bop approach

Current Account Balance


Capital Account Balance


Financial Account Balance


Balance of Payments


Reserve Balance






X exports, M imports

CI capital inflows, CO capital outflows

FI financial inflows, FO financial outflows

FXB official monetary reserves

Flow (BOP) Approach
  • Forex as a medium of exchange.
bop approach
BOP Approach
  • Fixed Exchange Rate Countries
    • Government bears responsibility to ensure BOP near 0.
    • If CA+CAP =/= 0, government must intervene
      • If government lacks reserves, will have to devalue.
  • Managed Float Countries
    • To “defend” currency, may raise interest rates.
    • => raises cost of capital for domestic firms
stock asset market approach
Stock (Asset Market) Approach
  • Forex as a store of value
  • Willingness to hold monetary claims depends on relative real interest rates & on country’s economic growth & profitability.
  • Asset approach “forward looking”: discounted future value
  • Movements in exchange rate reflect news.
  • Current exchange rate is set to equilibrate risk-adjusted expected return on assets denominated in different currencies.

Asset Model Approach

Monetary Approach

Portfolio-Balance Approach

imperfect capital substitutability

perfect capital substitutability

Risk premium = 0

Interest rate parity

Note: risk premium =/= 0

Forward rate biased predictor

Monetarist Model

completely flexible

commodity prices

Preferred Local

Habitat Model

Uniform Preference


Overshooting Model

sticky commodity prices

asset model monetary approach
Asset Model: Monetary Approach
  • Spot exchange rate is relative price of two monies.
  • Flexible price model: Domestic good prices fully flexible
    • If domestic money supply increases domestic currency will depreciate.
    • If domestic real income Y rises/ domestic interest rate i falls, domestic currency will appreciate as money demand is increased
  • Stick price model: Goods prices are sticky (slow to adjust) relative to asset prices.
    • Asset prices have to move by more than in flexible price case, in order for markets to reach equilibrium.
asset model portfolio balance
Asset Model: Portfolio-Balance
  • Portfolio-balance model has two financial assets (money & bonds) and two countries (home & foreign).
  • Exchange rate establishes equilibrium in investor portfolios of domestic money & domestic and foreign bonds.
  • Balance between domestic and foreign bonds in a portfolio is positively related to expected excess return on domestic bonds over foreign bonds.
  • Investors’ asset preferences may be similar across countries (uniform preference model), or investors may prefer assets of their home country (preferred local habitat model).
the portfolio balance approach

Impact on

home currency


Increase in:

supply of home country bonds

supply of foreign country bonds

domestic interest rates

foreign interest rate

expected rate of home currency


home wealth

home country current account


+ depreciates

- appreciates

- appreciates

+ depreciates

+ depreciates

- appreciates

- appreciates





The Portfolio-Balance Approach

Effects of Macroeconomic Shocks on forex

forecasting techniques
Forecasting Techniques

3 general types of forecasts:

  • Intuitive – expectations should be sufficient  efficient market approach
  • Monetary policy  fundamental approach.
  • History  technical approach.
efficient market approach
Efficient Market Approach
  • Markets are efficient & reflect all available information.
  • Markets will follow random walk by changing only when unpredicted events occur (i.e. news). St = E[St+1].
  • PPP can be interpreted as market’s consensus forecast of future exchange rates if markets efficient Ft,1 = E[St+1| It].
fundamental approach
Fundamental Approach
  • Exceedingly technical. Widely used in banks.
  • Heavy econometrics – 3-step process:
    • Estimate structural model.
    • Estimate future parameter values.
    • Use the model to develop forecasts.
technical approach
Technical Approach
  • “History repeats itself”.
  • Data mining in search of patterns.
  • Largely reliant on short-term & long-term moving averages and divining patterns in the graphs.
  • Not well-regarded in academia , but extremely popular among traders .
example of technical analysis
Example of Technical Analysis


forecasting in practice
Forecasting in Practice
  • Short-term forecasts: hedge receivable, payable, or dividend
  • Long-term forecasts: capital structure, entry mode of investment
  • Cross-rate consistency.
    • E.g. HQ forecasts Yen 120/$, $1.50/Pound
    • Regional managers forecast Yen 150/Pound.
    • => Inconsistency.
  • Stabilizing expectations.

Forecast Period Regime Recommended Methods to Forecast…

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?

2. Inflation?

3. Government interventions & news releases?

LONG-RUNFloating Rate 1. PPP & inflation.

2. Economic growth.

3. Technical analysis long-term trends; “waves”

anatomy of a crisis asia 97
Anatomy of a crisis -- Asia’97
  • What caused it? Supply driven: net exporters became net importers.
  • Thai banks had access to capital & US$ debt at low rates.
  • 1997: Thai Baht under attack due to country’s rising debt.
  • Thai government intervened directly selling reserves & indirectly raising interest rates.
  • Massive currency losses and bank failures led to July 1997, central bank allowed Baht to float.
  • Contagion:Taiwan devaluation (15%), Korea (18.2%), Malaysia (28.6%), Philippines (20.6%) against the $.
  • Not affected: Hong Kong $ and Chinese renminbi.
  • Countries had similar characteristics: corporate socialism, in-transparent corporate governance, banking liquidity and management.
asian crisis
Asian Crisis

Thailand’s Deteriorating Balance of Payments, 1991-1998Excess capital inflows, 1996 & 1997

Source: International Financial Statistics, IMF


Investors borrow 6.00% per annum



 1.06


$ 1,060,000 Repay

$ 1,160,000 Earn

$ 60,000 Profit

U S dollar money market

Continuing Uncovered

Interest Arbitrage

S =B 25.00/$

S360 = B 25.00/$

Thai baht money market

 1.12

B 25,000,000

B 28,000,000

Invest at 12.00% per annum

Thai Interest/Exch. Rate Disequilibria

360 days

russian crisis
Russian Crisis
  • During 1995-1998, Russian borrowers (public & private) tapped international markets for capital.
  • Servicing debt a problem as US$ were required for payments
  • Russian rouble operated under managed float w/in band of RU 5.75/$ to RU 6.35/$
  • Even after $4.3bn IMF facility, rouble fell under attack August 1998
  • Financing options dried up, debt issuance cancelled.
  • Russia began printing money for domestic payments.
  • Russia defaulted on foreign debt, first time Eurobond default.
  • Postponed $43bn short-term debt & 90-day moratorium on repayment of foreign debt.
brazilian crisis 1 1999 read on own
Brazilian Crisis – 1/ 1999(read on own)
  • Continuing CA deficits and domestic inflation puts in 1998 pressure on real
  • Heavy outflow of capital, stock market down.
  • Central bank raised short-term interest rates 36% -> 41%
  • April 1999, real appreciated against the dollar.
things to remember
Things to remember
  • BOP and asset market approaches to exchange rates.
  • Forecasting in practice.
  • How different theories combine to explain recent currency crises – Asia, Russia?