Beruflich Dokumente
Kultur Dokumente
Dr. C S Shylajan
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Introduction
An exchange rate is the relative price of one
currency in terms of another It influences allocation of resources within and across countries During the Bretton Woods era exchange rate was treated as an exogenous variable With the advent of floating rates in 1973, attention once again shifted to determinants of exchange rates themselves
Introduction
Exchange rates are affected by many factors. For instance, Balance of payments, inflation,
interest rates, money supply, political factors, market sentiments, technical factors etc.
Important ones are Price and Interest rates What is the relationship of these two variables with
exchange rates?
Parity theory.
Absolute form of PPP & Relative form of PPP Absolute form of PPP: Without international
Law of one price: Price of a specified bundle of goods and services, denominated in a given currency is same everywhere St = Ph / P*f
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PPP
PPP states that the exchange rate between
currencies of two countries is equal to the ratio between the prices of the two countries
rate between the currencies of the two countries will adjust the changes in the inflation rate of the two countries.
k : Some constant
Faster inflation at home Home currency depreciates at a rate equal to its excess inflation rate.
IF DURING A YEAR INFLATION IN US IS 5% WHILE INFLATION IN JAPAN IS 3%, DOLLAR WILL DEPRECIATE AGAINST THE YEN BY 2%. CHANGE IN EXCHANGE RATE EQUALS INFLATION DIFFEENTIAL. 11
percentage change in the spot exchange rate equals the difference in the inflation rates divided by 1 plus the inflation rate in country B Example: If the inflation rate in India (country A) is 10% and that in the US (country B) it is 3%, the Rs/$ rate would change over a period of one year by (0.10-0.03)/(1+.03) =0.068 =6.8 % Indian rupee will depreciate by 6.8 %
exchange rate between two currencies adjusted for relative purchasing power of the currencies
Re = Ste (Pd/Pf)
while Ptd and Ptf are price indices (say CPIs) in countries A and B with reference to a common base year. The real exchange rate Rt is also expressed as an index with reference to the same base year
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exchange under a forward contract? A forward exchange rate is the rate that is currently paid for the delivery of a currency at some future date. It has the spot rate as its base, plus the interest factor. The interest factor which is factored into the rate is called the interest rate parity
OTHER BASIC RELATIONSHIPS COVERED INTEREST PARITY: AMONG CONVERTIBLE CURRENCIES SPOT-FORWARD MARGIN EQUALS INTEREST RATE DIFFERENTIAL INTEREST RATE DIFFERENTIAL EQUALS EXPECTED CHANGE IN EXCHANGE RATE. UIP NOT FOUND EMPIRICALLY VALID (WHY?)
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constant The nominal and real exchange rates we have considered are bilateral rates The concept of Effective Exchange Rate (EER) is utilized to make multilateral comparisons Nominal EER (NEER) captures movements in a currency vis--vis a basket of currencies. Real Effective Exchange Rate (REER) attempts to capture changes in competitiveness vis-a-vis a group of competitors in world markets rather than pair-wise comparisons. It is NEER adjusted for inflation differences between home and basket currency countries
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Exchange Rate Behaviour and Predictor Absolute PPP does not hold in practice. Reasons are transport costs, non-homogeneous goods, non-traded goods, trade barriers, non-homogeneous tastes etc. Relative PPP is found to hold approximately over long periods of time several years. Not very useful for short-term prediction of exchange rates Can provide an indication of long term trends if inflation trends can be reasonably assessed.
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i=r+
where i = nominal interest rate; r = real interest rate; and rate = inflation
internationally, the real rate of interest should be the same in all countries (otherwise it will create an arbitrage opportunity)
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e= S
Take UIP
A-
iA iB =
= TeA - TeB
iA - TeA = rA iB - TeB = rB
This implies that with free capital flows and risk neutral
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supported by two countries currencies will cause an equal but opposite change in their spot exchange rates countries
Real interest rates are theoretically equal across Any difference in interest rates in two countries
that of another country should see the value of its currency fall
The exchange rate must be adjusted to reflect this
change in value.
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Introduction
Many theories on the exchange rate determination Exchange rates (floating), like any price, is determined
The problem is to correctly model all the factors that Another complication is that foreign exchange is an
influenced by expectations about future course of price events, political developments, technological developments, resource discoveries, etc.
Exchange rate theories can be used for exchange But prediction of the exact level of future exchange
players in the international markets and also for the speculators. unbiasedness
factors that affect the demand and supply of a currency Therefore, this approach also known as balance-ofpayments approach these demands and supplies
Exchange rate is the equilibrium price that equates Different models of exchange rates differ in the
emphasis they put on the different components of demand for and supply of a currency
and supply of foreign exchange arising out of imports and exports (known as Flow Models) depreciates, imports become more expensive while exports become cheaper in terms of foreign currency
Demand for imports falls while for exports expands Supply of foreign currency rises while demand shrinks,
economic growth at home, etc), other things remaining the same, the home currency will depreciate
problems in export industries, economic slow down in buyer country, competition, etc), home currency depreciate that for exports rises, the home currency appreciate
influenced by the forces affecting demand and supply of imports and exports affect the level of economic activity, productivity changes, changes in consumer preferences, tariffs and trade barriers, etc
S D
No. of Dollars
Figure 1
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is only an instrument to correct the temporary imbalance in the system At the same time, imported goods are more expensive due to depreciation, reducing imports This improves the current account balance But despite a depreciation, the current account balance may worsen. Why? J-curve effect
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may increase, but the amount of foreign currency earned from those exports may decrease. exports.
the short run but price elastic in the long run, volume of exports and imports do not immediately respond to the change in relative prices of exports and imports, caused by depreciation of currency. This leads to deterioration in the Balance of Trade. Then currency depreciates further.-J Curve
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capital account
between home and the ROW Income and exchange rate; rate differential
Current account balance depends upon the National Capital account balance depends upon the interest National income and interest rates are influenced by
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According to this approach, exchange rates are essentially monetary phenomena. Assumptions: There is only one asset viz. money. Residents of a country hold only that countrys money. Purchasing Power Parity holds (an increase in countrys price level results in the depreciation of that countrys currency and vice versa)
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domestic residents, when faced with a discrepancy between the stock of (domestic) money they wish to hold and the actual stock of money created by the monetary authority, will attempt to correct it by running a balance of payments deficit or surplus
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increase in the real money demand With no change in money supply, lesser money is left for purchase of goods, services that brings down the price level A reduction in price level causes appreciation of the currency Thus, increase in real GNP brings an appreciation of the currency Suppose, there is excess supply of money, resulting in increased demand for domestic as well as foreign goods The domestic price level rises and the exchange rate depreciates 38
economic growth coupled with moderate growth in money supply and credit will result in a strong and stable currency, while excessive credit creation, especially when the economy is not growing rapidly, will cause a fall in currency
episodes?
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country interest rate, given other things, will lead to a depreciation of a home currency
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Expectations, the Efficient Markets Hypothesis and the Role of "News" EMH does not talk about the effect of changes in the basic economic variables. Current exchange rate is the reflection of the expectations of the market as a whole.
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number of corporate financial decisions Forecasting methodologies can be divided into two broad categories Structural economic models of exchange rate determination such as the PPP or the monetarist model Pure forecasting models" that includes time series methods and "technical analysis" Recent developments in modeling and predicting financial time series have applied mathematical tools. Composite Forecasts A combination of different forecasts
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How much does the forecast contribute to better decision making given that the firm has its own sources of information and is able to generate its own forecasts The forward rate is always available as a forecast free of charge. Any forecast paid for must do considerably better than forward rate in predicting direction and magnitude of movement
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prevent panics.
trade related flows since the capital account continues to be strictly controlled generate significant volatility in the rupee exchange rate as we have seen recently.
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Thanks