Foreign

Exchange Rate Determination

and Forecasting

Chapter 9

Foreign Exchange Rate Determination
Exchange rate determination is complex.
Exhibit 9.1 provides an overview of the many determinants of
exchange rates.
This road map is first organized by the three major schools of
thought (parity conditions, balance of payments approach,
asset market approach), and secondly by the individual
drivers within those approaches.
These are not competing theories but rather complementary
theories.
Exhibit 9.1 The Determinants of
Foreign Exchange Rates
Foreign Exchange Rate Determination
Without the depth and breadth of the various approaches
combined, our ability to capture the complexity of the global
market for currencies is lost.
In addition to gaining an understanding of the basic theories,
it is equally important to gain a working knowledge of:
the complexities of international political economy;
societal and economic infrastructures; and,
random political, economic, or social events that affect the exchange
rate markets.


Exchange Rate Determination: The
Theoretical Thread
The previous exhibit, with its tripartite
categorization of exchange rate theory is a
good start but in our humble opinion is not
robust enough to capture the multitude of
theories and approaches.

Therefore, in the following slides, we will
introduce several additional streams of
thought.
Exchange Rate Determination: The
Theoretical Thread
The theory of purchasing power parity is the
most widely accepted theory of all exchange
rate determination theories:
PPP is the oldest and most widely followed of the
exchange rate theories.
Most exchange rate determination theories have
PPP elements embedded within their frameworks.
PPP calculations and forecasts are however
plagued with structural differences across
countries and significant data challenges in
estimation.
Exchange Rate Determination: The
Theoretical Thread
The balance of payments approach is the
second most utilized theoretical approach in
exchange rate determination:
The basic approach argues that the equilibrium exchange
rate is found when currency flows match up vis--vis current
and financial account activities.
This framework has wide appeal as BOP transaction data is
readily available and widely reported.
Critics may argue that this theory does not take into account
stocks of money or financial assets.
Exchange Rate Determination: The Theoretical Thread
The monetary approach in its simplest form
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.
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.
Exchange Rate Determination: The Theoretical Thread
The asset market approach argues that
exchange rates are determined by the supply
and demand for a wide variety of financial
assets:
Shifts in the supply and demand for financial
assets alter exchange rates.
Changes in monetary and fiscal policy alter
expected returns and perceived relative risks of
financial assets, which in turn alter exchange
rates.
Exchange Rate Determination: The Theoretical Thread
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.
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 or drivers (among others):
Relative real interest rates
Prospects for economic growth
Capital market liquidity
A countrys economic and social infrastructure
Political safety
Corporate governance practices
Contagion (spread of a crisis within a region)
Speculation
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 asset market approach is also applicable
to emerging markets; however in these cases,
a number of additional variables contribute to
exchange rate determination (previous slide).
Currency Market Intervention
(Why?)
Foreign currency intervention is the active
management, manipulation, or intervention in
the markets valuation of a countrys currency.
Why Intervene?
Fight inflation (strong currency)
Fight slow economic growth (weak currency)
Currency Market Intervention
(How?)
Methods of intervention are determined by
magnitude of a countrys economy, magnitude
of trading in its currency, and the countrys
financial market development
Direct Intervention
the active buying and selling of the domestic
currency against foreign currencies
If the goal is to increase the value, then the central
bank buys its own currency
If the goal is to decrease the value, then the
central bank sells its own currency


Currency Market Intervention
(How?)
If bank intervention is insufficient, then coordinated
intervention may be used whereby several central banks agree
on a strategy to increase or decrease a currency value.
Indirect Intervention is the alteration of economic or financial
fundamentals which are thought to be drivers of capital to
flow in and out of specific currencies.
Increase real rates to strengthen a currency
Decrease real rates to weaken a currency


Currency Market Intervention
(How?)
Capital Controls are restrictions of access to
foreign currency by the government by
limiting the exchange of domestic currency for
foreign currency.

Disequilibrium: Exchange Rates
in Emerging Markets
Although the three different schools of thought on exchange rate
determination (parity conditions, balance of payments approach, asset
approach) make understanding exchange rates appear to be
straightforward, that it rarely the case.
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.
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 1996 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.
Illustrative Case: The Asian Crisis
The Thai government intervened directly (using up precious
hard currency reserves) 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 (see Exhibit 9.2) and soon other
Asian currencies (Philippine peso, Malaysian ringgit and the
Indonesian rupiah) came under speculative attack.
Exhibit 9.2 The Thai Baht and the
Asian Crisis
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 socialism
Corporate governance
Banking liquidity and management
What started as a currency crisis became a
region-wide recession.
Illustrative Case: The Russian Crisis of 1998
Debt service had become a real problem
Capital flight was taking place
The ruble traded via a managed float that had been
continually adjusted since 1996
August 7, 1998 began the August Crash with the
announcement that currency reserves had fallen $800M in the
last week
August 10, the Russian stock market falls 5%
August 17, Russia announces the ruble will be allowed to
devalue by 34%
Exhibit 9.3 illustrates the rubles decline
Exhibit 9.3 The Fall of the Russian
Ruble
Illustrative Case:
The Argentine Crisis of 2002
In 1991 the Argentine peso had been fixed to
the U.S. dollar at a one-to-one rate of
exchange.
A currency board structure was implemented
in an effort to eliminate the source inflation
that had devastated the nations standard of
living in the past.
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 overvalued
The currency board regime had eliminated
monetary policy alternatives for macroeconomic
policy
The Argentine government budget deficit and
deficit spending was out of control
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.
Exhibit 9.4 tracks the decline of the Argentine peso

Exhibit 9.4 The Collapse of the
Argentine Peso
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-day
Short-term (several days to several months)
Long-term
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.
Exhibit 9.5 summarizes the various forecasting periods,
regimes, and the authors suggested methodologies.

Exhibit 9.5 Exchange Rate
Forecasting in Practice
Forecasting: What to Think?
It appears, from decades of theoretical and
empirical studies, that exchange rates do
adhere to the fundamental principles and
theories previously outlined.
Fundamentals do apply in the long term
There is, therefore, something of a
fundamental equilibrium path for a currencys
value.
Forecasting: What to Think?
It also seems that in the short term, a variety of random
events, institutional frictions, and technical factors may cause
currency values to deviate significantly from their long-term
fundamental path.
This behavior is sometimes referred to as noise.
Therefore, we might expect deviations from the long-term
path not only to occur, but to occur with some regularity and
relative longevity.
Exhibit 9.6 illustrates the synthesis of forecasting thought.
Exhibit 9.7 shows the dynamics of exchange rate manipulation.

Exhibit 9.6 Short-Term Noise
Versus Long-Term Trends
Exhibit 9.7 Exchange Rate
Dynamics: Overshooting