MBASess6AExRateDet09
Transcript of MBASess6AExRateDet09
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Professor Augustine H H Tan MBA Global Economy 1Session 6A-09
Exchange rates
Exchange Rate Determination
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Professor Augustine H H Tan MBA Global Economy 2Session 6A-09
Introduction
Forces underlying exchange-rate fluctuations
A system of market-determined (floating) exchangerates
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Professor Augustine H H Tan MBA Global Economy 3Session 6A-09
What Determines Exchange Rates?
Market fundamentals Market expectations
Determinants are different for short run, mediumrun, and long run cycles
Framework in which exchange rates aredetermined (Fig 12.1)
Example of Forex View column (Table 12.1)Table
12.1
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Professor Augustine H H Tan MBA Global Economy 4Session 6A-09
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Professor Augustine H H Tan MBA Global Economy 5Session 6A-09
Determining Long-Run Exchange Rates
Four key factors - Summary (Table 12.2)
Relative price levels: (Figure 12.2(a)) Relative productivity levels: (Figure 12.2(b))
Preferences for domestic or foreign goods: (Figure12.2(c))
Trade barriers: (Figure 12.2(d))
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Professor Augustine H H Tan MBA Global Economy 6Session 6A-09
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Professor Augustine H H Tan MBA Global Economy 7Session 6A-09
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Professor Augustine H H Tan MBA Global Economy 8Session 6A-09
Inflation Rates, Purchasing Power Parity, Long-RunExchange Rates
Law of one price
An identical good should cost the same in allnations, assuming costless shipping and nobarriers
Theory: Pursuit of profits and price equalization
Single price might not apply in practice Big Mac index
Primitive and has many flaws but widelyunderstood
Serves as an approximation of currencystrength
Price of a Big Mac (Table 12.3)
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Professor Augustine H H Tan MBA Global Economy 9Session 6A-09
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Professor Augustine H H Tan MBA Global Economy 10Session 6A-09
Purchasing Power Parity
Purchasing power parity theory
Exchange rates are related to differences in thelevel of prices between two countries
Changes in relative national price levelsdetermine changes in exchange rates over thelong run
Given in symbols as:
Application of the concept (Table 12.4)
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Professor Augustine H H Tan MBA Global Economy 11Session 6A-09
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Professor Augustine H H Tan MBA Global Economy 12Session 6A-09
Purchasing Power Parity
Limitations of the theory
Overlooks the fact that exchange-rate movementsmay be influenced by investment flows
Choosing the appropriate price index
Determining the equilibrium period base Government policy interference
Predictive power most evident in the long run
Purchasing power parity: U.S.-United Kingdom(Figure 12.3)
Continued
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Professor Augustine H H Tan MBA Global Economy 13Session 6A-09
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Professor Augustine H H Tan MBA Global Economy 14Session 6A-09
Determining Short-Run Exchange Rates: The Asset-MarketApproach
Key factors governing investment decisions
Relative levels of interest rates Expected changes in the exchange rate, over the
term of the investment
Effects of these factors(Table 12.5)
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Professor Augustine H H Tan MBA Global Economy 15Session 6A-09
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Professor Augustine H H Tan MBA Global Economy 16Session 6A-09
Relative Levels of Interest Rates
Differences in the level of nominal interest rates affectinvestment flows
Relative interest rates as a determinant of exchange rates(Figure 12.4a)
Distinguishing between the nominal interest rate and the realinterest rate
Real Interest Rate = Nominal Interest Rate Rate of Inflation
Short-term real interest rates (Table 12.6)Real Interest Rate = Nominal Interest Rate - Inflation Rate
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Professor Augustine H H Tan MBA Global Economy 17Session 6A-09
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Professor Augustine H H Tan MBA Global Economy 18Session 6A-09
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Professor Augustine H H Tan MBA Global Economy 19Session 6A-09
Expected Change in theExchange Rate
To determine the actual earnings from an investment
in another currency High interest rate may not be attractive enough if
denominating currency is expected to depreciate
If the denominating currency is expected to
appreciate, the realized gain would be greater
Effects of investor expectations of changes inexchange rates (Figure 12.4(b))
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Professor Augustine H H Tan MBA Global Economy 20Session 6A-09
Diversification, Safe Havens, and Investment Flows
Diversification across asset types
Including the currencies in which they aredenominated
Safe-haven effect
Sacrificing returns for lower risk
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Professor Augustine H H Tan MBA Global Economy 21Session 6A-09
The Ups and Downs of the Dollar: 1980 to 2005
The 1980s
Path of appreciation and then depreciation
Peaked in 1985; 50% above 1979 levels
Depreciation in latter half of 1980s
Fluctuations significantly caused by policychanges
The 1990s
Economic weakness; recession in 1991
Rapid growth in the mid-1990s
Appreciation: 1995-2001
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Professor Augustine H H Tan MBA Global Economy 22Session 6A-09
The Ups and Downs of the Dollar: 1980 to 2005
The 2000s
A rising dollar and the large flow of investment intothe U.S. that pushes the currency higher could notbe sustained
Depreciation in 20022004
Weakening of the demand for dollar-denominated assets on the part of foreigninvestors
Reversal by 2005 Strong economic performance
Continued
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Professor Augustine H H Tan MBA Global Economy 23Session 6A-09
Exchange-Rate Overshooting
Short-run response to a change in market
fundamentals greater than long-run response Helps explain sharp movements
Tendency of elasticities to be smaller in the shortrun than in the long run (Figure 12.5)
Exchange rates tend to be more flexible than manyother prices
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Professor Augustine H H Tan MBA Global Economy 24Session 6A-09
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Professor Augustine H H Tan MBA Global Economy 26Session 6A-09
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Professor Augustine H H Tan MBA Global Economy 27Session 6A-09
Forecasting Foreign-Exchange Rates
Judgmental forecasts
Subjective or common sense models
Projections based on a thorough examination ofindividual nations
Use of economic indicators; political factors;technical factors; and psychological factors
Technical forecasts
Involves the use of historical exchange-rate data to
estimate future values (Figure 12.6)
Useful in explaining short-term movements
Continued
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Professor Augustine H H Tan MBA Global Economy 28Session 6A-09
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Professor Augustine H H Tan MBA Global Economy 29Session 6A-09
Forecasting Foreign-Exchange Rates
Fundamental analysis
Involves consideration of economic variables thatare likely to affect a currencys value
Uses computer-based econometric models
Best suited for forecasting long-run trends
Continued
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Professor Augustine H H Tan MBA Global Economy 30Session 6A-09
Forecast Performance of Advisory Services
Better information about future exchange rates than is
available to the market Evaluating the performance of forecasters
Predict spot rates better than what is implied by theforward rate
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Professor Augustine H H Tan MBA Global Economy 31Session 6A-09
Factors influencing exchange rates
Real income differentials
A country with faster economic growth than the restof the world will have a depreciating currency (otherthings being equal)
Imports rise faster than exports, so demand forforeign currency rises faster than its supply
Real income changes can also reflect otherprocesses, which might lead to rising exports
F t i fl i h t
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Professor Augustine H H Tan MBA Global Economy 32Session 6A-09
Impact of real income differentials
Factors influencing exchange rates
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Professor Augustine H H Tan MBA Global Economy 33Session 6A-09
Real Income Rise Due to Productivity
Increase, FDI Increase
$/
Millions of
S
S*
D
Exchange rate markets
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Professor Augustine H H Tan MBA Global Economy 34Session 6A-09
Exchange rate markets
Asset-Markets Approach to Exchange-Rate
Determination
Residents hold a spectrum of financial assets:domestic currency, foreign currency,
domestic/foreign securities Continuing Flow component
Stock adjustment component emphasized
Key determinant of short-run movements inexchange rates
Asset allocation between home and foreign dependson:
interest rate on domestic securities Interest rate on foreign securities
expected change in exchange rate.
Alternative approaches to exchange rates
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Professor Augustine H H Tan MBA Global Economy 35Session 6A-09
Equilibrium in asset-markets approach
Alternative approaches to exchange rates
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Professor Augustine H H Tan MBA Global Economy 36Session 6A-09
Asset-markets approach: shift in demand
Alternative approaches to exchange rates
Alternative approaches to exchange rates
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Professor Augustine H H Tan MBA Global Economy 37Session 6A-09
Asset-markets approach: shift in supply
Alternative approaches to exchange rates