Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

FOREIGN EXCHANGE RATE THEORIES

Four theories

•Purchasing Power Parity

•Interest Rate Parity

Fisher condition for capital market equilibrium

Expectations theory of forward rates

THE DETERMINANTS OF FOREIGN EXCHANGE RATES

1-2

Parity Conditions1. Relative inflation rates2. Relative interest rates3. Forward exchange rates4. Interest rate parity

Balance of Payments1. Current account balances2. Portfolio investment3. Foreign direct investment4. Exchange rate regimes5. Official monetary reserves

Asset Approach1. Relative real interest rates2. Prospects for economic growth3. Supply & demand for assets4. Outlook for political stability5. Speculation & liquidity6. Political risks & controls

SpotExchange

Rate

Is there a well-developedand liquid money and capitalmarket in that currency?

Is there a sound and securebanking system in-place to supportcurrency trading activities?

INTERNATIONAL PARITY RELATIONSHIP

1-3

• To reduce the effect of disparities caused by-

• Arbitrage , speculation etc

• This economic behaviour- ‘law of one price’

• Four theories come into practice

EXCHANGE RATE DETERMINATION THEORIES

1.Interest rate parity:

Relationship between interest rates and

Exchange rates of two countries

1-4

Exchange rate of two countries will be affected by their interest rate differential

Currency of a high interest rate country will be at a forward discount-

Relative to the currency of a low interest rate country

1-5

Exchange rate(forward& spot) differential will be equal to the interest rate differential between two countries

Interest differential=exchange rate(F&S)differential

1+rf = f F/D 1+rd s F/D

1-6

rf = Interest rate of country F

rd= Interest rate of country D

sF/D = Spot exchange rate of country F&D

fF/d= Forward rate between country F&D

Note : High interest rate:-Forward discount Low interest rate :- Forward premium

1-7

Concept:- Interest rate parity works fairly well -internal

markets There is no restriction from one country to

other

Euro currency market are the international capital market –minimum restrictions and control

Here the market forces determine interest rates

1-8

2. Theory of Purchasing Power Parity:

The oldest, and most widely accepted theory Concept:

Exchange rate between the currencies of two countries equals the ratio between the prices of goods in these countries

1-9

Purchasing power states – The exchange rate between the currencies of

two countries will adjust Purpose: To reflect changes in the inflation rates of the

two countries

Inflation rate differential= current spot & expected spot rate differential

1-10

1+iF = E(SF/D) 1+iD sF/D

iD= Rate of inflation in country D iF= Rate of inflation in country F

sF/D= Spot exchange rate between country F&D

E(SF/D)=Expected spot rate between country F&D in future 1-11

3. Expectation theory of forward rates:

Expected future spot rate depends on the expectations of the FOREX market participants

Concept:

When the forward rate is higher than the market participants prediction-

1-12

Participants will tend to sell the foreign currency forward

Cause a fall in the forward rate

Until it equals the expected future spot rate

1-13

Forward rate& the current rate differential must be equal to the expected spot rate & the current spot rate differential

F&C spot rate differential=Expected & Current spot rate differential

1-14

fF/D = E(Sf/d) sF/D s F/D

E( Sf /D)=Expected future spot exchange rate for a unit of foreign currency per unit of domestic currency

f F/D =forward rate between countries F&D

1-15

4.International Fisher Effect:

Nominal interest rate comprises of a real interest rate and an expected rate of inflation

Nominal interest rate adjust when the inflation rate is expected to change

Concept:

1-16

Nominal interest rate will be higher :–When a higher inflation rate is expected

It will be lower when a lower inflation rate is expected

1+nominal interest rate=(1+real interest rate)(1+inflation rate)

1+rn =(1+rr)(1+i)

1-17

rn= rr+i+rri

rn= Nominal rate of interest

rr= Real rate of interest

i= Inflation rate

1-18

International Fischer Effect –

Nominal interest rate differential must equal to the expected inflation rate differential in two countries

Nominal interest rate differential=expected inflation rate differential

1-19

1+rf = E(1+if) 1+rn E(1+if)

1-20

EXCHANGE RATE MECHANISM

There is a price for any purchase or sale of a currency

Such a price in the exchange market is called the exchange rate

Definition:

The no.of units of one currency that will be exchanged for a unit of another currency

1-21

EXCHANGE RATE OF ANY CURRENCY CAN BE EXPRESSED IN TWO WAYS

1.In terms of foreign currency units against a given unit of domestic currency

Eg Rs.45=$1

2.In terms of the no.of domestic currency units against a given unit of foreign currency

Eg:$1=Rs.45

1-22

Exchange rate depends on the supply and demand for a currency

Supply and demand depends on : Arbitrage and interest rate speculation, Currency speculation and Short-term capital flows

1-23

GUSTAV’S THEORY

Prof. Gustav Cassel-purchasing power parity theory

Exchange rates are determined by what each unit of a currency can buy in terms of real goods and services in its own country

Rate of exchange is the amount of currency which would buy the equivalent basket of goods and services in both countries

1-24

There should be comparison between currencies at two periods of time

One year as the basis of comparison

But no absolute comparison between two currencies are possible

1-25

It is assume that the base year prices in both the countries are at equilibrium

Exchange ratio at that time represents ratio of their purchasing powers

1-26

E.g.. If base period exchange rate is 1:1 a doubling of prices in the domestic economy of B with A’S price remaining constant.

These lead to a new exchange rate of 1:2

This ratio would set the bounds or limits to day –to-day fluctuations in the exchange rates

1-27

SPOT AND FORWARD RATES

Importer is paying on receipts of documents He can buy dollars spot and The bank sells him spot dollars

If importer agrees to pay at a later date His demand arise only at a later date These dollars are called forward dollars The market is a forward market

1-28

Existence of forward market provides cover- Or hedge against fluctuations in the spot

exchange rates This exchange risk falls on the bank who are

buying or selling dollars forward Banks can pass the risk to central bank Forward purchase or sale of currencies

include interest rate fluctuations

1-29

Forward currency may be quoted at premium or at discount

E.g.: premium(higher than the spot expressed in foreign currency per domestic unit quoted)

2003 Rs. 100=$2.7555, if interest rates abroad are higher than at home

1-30

SPECULATION

Speculation and hedging are taking place in free market

It take advantage of interest rate andexchange rate differentials Speculation on a limited scale is healthy It should be on both sides of purchase and

sale

NOTE: Not possible in India where banks are allowed only to keep a minimum balance of cash

1-31

ARBITRAGE

Exchange rate of currencies are same in all the centers

For eg. If dollar rate per sterling is different in New

York and Frankfurt Then funds would flow in either direction to

take advantage of the rate differential

1-32

Slight differentials might be still there due to :

Carrying costs of moving funds from one place to another

Operations in terms of movement of funds from one centre to another

Known as arbitrage operations Arbitrage can be three point or multi point E.g.. moving funds from dollar to franc , franc

to sterling, sterling to dollar1-33

TYPES OF EXCHANGE RATE

1.Floating Vs. Fixed rates Traditional floating systems are: Single float, joint float , managed float etc Fixed rates come into existence after the

break down of Breton woods system in August 1971

Floating rate is the rate which is freely allowed to fluctuate

According to the supply and demand situation 1-34

If no intervention by central bank it is known as free float

Some degree of intervention exists which lead to a managed float

Managed float can be either single or joint When various currencies were floating with

varying degree of intervention- within a band of 2.25% on either side are

single float

1-35

The European Common Market countries are under a joint float with in a narrow band called ‘snake in the tunnel’

ECM-west Germany, France , Belgium, Netherlands, Luxemburg and Ireland, Denmark and Sweden

Indian rupee is kept stable still 1991

1-36

Then rupee devalued and Limited Exchange Management System (LERMS)

FERA was diluted Banks are allowed greater freedom of lending Deposit and lending rates are freed Now FERA is changed to FEMA in 2000

1-37

QUOTATIONS

Now quotations are called ‘direct quotes’ Principle the banker follows is to give two

way quotes-based on ‘give less and take more’ The spread between the buying and selling

rates is the banks profit Spread depends on the cable cost ,

brokerage cost and administrative cost

1-38

E.g.; if the quotation is$1=Rs.45.750-45.780 First is the purchase price Second is the selling price Principle is ‘buy low sell high’

1-39

METHOD OF QUOTATION

1. Direct method: Gives no . of currency units of domestic

country to one unit of foreign currency 2.Indirect method: Gives no . of foreign currency units for one

unit of domestic currency

1-40

E.g. indirect method: For Rs.100= US-2.99 UK-1.21 EURO-1.76 Pakistan-136.1 Malaysia-8.7 China-18.97

1-41

DIRECT METHOD

As on June 30,2005 1 USD=Rs.43.5150 1UKsterling=Rs.79.6988 1Euro=Rs.52.6425 1ooYen=Rs.39.5200 SOURCE : Official quote of RBI

1-42

EXCHANGE RATE CALCULATION

Spot TT buying rate

1-43

EXCHANGE RATE DETERMINATION: THEORIETICAL APPROACH

The balance of payments approach is the most utilized theoretical approach in exchange rate determination: demand and supply of a currency reflected in

current and financial accounts determines the exchange rate.

This framework has wide appeal as balance of payment transaction data is readily available and widely reported.

This theory does not take into account stocks of money or financial assets.

1-44

EXCHANGE RATE DETERMINATION: THEORIES

The monetary approach 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.

Changes in money stocks affect the inflation rate, which in turn affects the exchange rates through the PPP effect.

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. 1-45

EXCHANGE RATE DETERMINATION: THEORIES

The asset market approach argues that exchange rates are determined by the supply and demand for a wide variety of financial assets. Changes in monetary and fiscal policy alter

expected returns and relative risks of financial assets, which in turn alter exchange rates. Mundell-Fleming proposed this view.

1-46

EXCHANGE RATE DETERMINATION: THEORIES

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.

1-47

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: Relative real interest rates Prospects for economic growth Capital market liquidity A country’s economic and social infrastructure Political safety Corporate governance practices Contagion (spread of a crisis within a region) Speculation

1-48

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 experience of the U.S. is the case in point. U.S. dollar strengthened despite growing current account deficits during the 1981-85, 1990 and 2000. Foreign capitals flowed into U.S. due to rising stock and real estimate prices, low inflation and relatively high real returns, low political risk

1-49

However, the 9/11 attack caused a negative assessment of long-term prospect for growth and profitability, and political risk in the U.S.

Loss of confidence in the U.S. economy led to a large outflow of foreign capital and subsequently depreciation of U.S. dollar by 18% between Jan-July 2002.

1-50

3. DISEQUILIBRIUM: EXCHANGE RATES IN EMERGING MARKETS The asset market approach is also applicable

to emerging markets, however in these cases a number of additional variables contribute to exchange rate determination.

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. 1-51

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.

1-52

ILLUSTRATIVE CASE: THE ASIAN CRISIS The Thai government intervened directly in

the fx market 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 and soon other Asian currencies (Philippine peso, Malaysian ringgit and the Indonesian rupiah) came under speculative attack.

1-53

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.

1-54

EXHIBIT 5.3 COMPARATIVE DAILY EXCHANGE RATES: RELATIVE TO THE US$

1-55

INSERT EXHIBIT 5.3

Apr97

Sep97

Jan98

Mar98

May98

Jul98

Jun97

Aug97

Nov97

May97

Oct97

Jul97

Dec97

Feb98

Apr98

Jun98

Aug98

Sep98

120

110

100

90

80

70

60

50

40

30

20

10

Philippine PesoThai BahtMalaysian RinggitIndonesian Rupiah

ILLUSTRATIVE CASE: THE RUSSIAN CRISIS OF 1998

The crisis of August 1998 was the culmination of a continuing deterioration in general economic conditions in Russia.

From 1995 to 1998, Russian borrowers (both government and non-governmental) had gone to the international capital markets for large quantities of capital.

Servicing this debt soon became an increasing problem, as it was dollar denominated and required dollar denominated debt service.

1-56

ILLUSTRATIVE CASE: THE RUSSIAN CRISIS OF 1998

The Russian current account (while a healthy surplus of $15 - $20 billion per year) was not finding its way into internal investment and external debt service.

Capital flight began to accelerate, and hard currency earnings flowed out of the country.

As the Russian rouble operated under a managed float, the Central Bank had to intervene in foreign exchange markets to support the currency if it came under pressure.

1-57

ILLUSTRATIVE CASE: THE RUSSIAN CRISIS OF 1998

During the month of August, 1998, the Russian government continued to drain its reserves and had increasing difficulties in raising additional capital in support of its reserves on the international markets.

By mid-August, the Russian Central Bank announced it would allow the rouble to fall, postponed short-term domestic debt service and initiated a moratorium on all repayment of foreign debt owed by Russian banks and private borrowers to avert a banking collapse. 1-58

EXHIBIT 5.4 DAILY EXCHANGE RATES: RUSSIAN RUBLES PER US$

1-59Jun98

Nov98

Mar99

May99

Aug98

Oct98

Jan99

Jul98

Dec98

Sep98

Feb99

Apr99

27.5

25.0

22.5

20.0

17.5

15.0

12.5

10.0

7.5

5.0

ILLUSTRATIVE CASE: THE ARGENTINE CRISIS OF 2002

In 1991 the Argentine peso had been fixed to the US dollar at a one-to-one rate of exchange.

A currency board structure was implemented in an effort eliminate the source inflation that had devastated the nation’s standard of living in the past.

1-60

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

1-61

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.

1-62

EXHIBIT 5.7 THE COLLAPSE OF THE ARGENTINE PESO

1-6302023162 889 722 16 30 3132

3.75

3.50

3.25

3.00

2.75

2.50

2.25

2.00

1.75

1.50

1.25

1.00

0.75

Jan 2002 Feb 2002 Mar 2002

4. FORECASTING IN PRACTICETechnical 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-dayShort-term (several days to several

months)Long-term

1-64

FORECASTING IN PRACTICE

Numerous foreign exchange forecasting services exist, many of which are provided by banks and independent consultants.

Some multinational firms have their own in-house forecasting capabilities.

Predictions can be based on elaborate econometric models, technical analysis of charts and trends, intuition, and a certain measure of gall.

The usefulness of the forecasting services depends on the motive for forecasting and the required accuracy of the forecast.

1-65

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.

1-66

EXHIBIT 5.10 DIFFERENTIATING SHORT-TERM NOISE FROM LONG-TERM TRENDS

1-67

Time

Foreign currency perunit of domestic currency

FundamentalEquilibrium

Path

Technical or random events may drive the exchange

rate from the long-term path

EXHIBIT 5.11 EXCHANGE RATE DYNAMICS: OVERSHOOTING

1-68

S0

t1 t2

S1

S2

Spot ExchangeRate, $/

Overshooting

Time

MINI-CASE QUESTIONS: JP MORGAN CHASE’S FORECASTING ACCURACY?

How would you actually go about calculating the statistical accuracy of these forecasts? Would Vesi have been better off using the current spot rate as the forecast of the future spot rate, 90 days out?

Forecasting the future is obviously a daunting challenge. All things considered, how well do you think JPMC is doing?

If you were Vesi, what would you conclude about the relative accuracy of JPMC’s spot rate forecasts?

1-69