Currencies & exchange rate mechanics

Presentation includes:•Factors affecting Currency Exchange Rate •Economical Formulas and •Prediction Models

Presented byVivek Kumar Singh

Vanshja GoiralaAjay Singh

Introduction – Is there a fair exchange rate P*?

• For equities, it is the net discounted cash flow of future earnings

• For bonds, it is the net discounted cash flow of future interest payments + principal

• For currencies? There is no universally agreed model of fair value!

Factors affecting exchange rates

Forecasting methodology (for short horizon)

Prediction Models (for long horizon)

• Random Walk model (RW)• Purchasing Power Parity model (PPP)• Uncovered Interest Rate Parity model (UIP)• Sticky Price Monetary model (SP)• Econometric Model• Dornbusch-Frankel monetary model• Hybrid model of monetary factors and productivity

differentials (HBS model)• Taylor Rule Models• Artificial Neural Network based Prediction models• Feed Forward Neural Network (FFNN)• Standard Backpropagation (SBP)• Scaled Conjugate Gradient (SCG)• Backpropagation with Bayesian Regularization (BPR)

U.S Dollar and Swiss FrancUSDCHF

History

Current Exchange Rate

•1 U.S. dollar / Swiss franc = 0.940949757

How inflation affects the fair value P* of USDCHF

CHF finding fair value P* through PPP

Recent Debacle

The Swiss market recorded its biggest daily percentage rise for 25 years on 15/1/2015.

The euro fell about 14.5% against the franc, falling as much as 30%. 

Cause* SNB promising a

rate of minus 0.25% and unpegging against USD

Unprecedented Volatility & Aftermath

FXCM Faces Losses on Franc Trades as Swiss Shock Spreads

The value of country's currency reserves went

down by 60 billion francs

FXCM Inc shares dip back below $2 as investors begin to lose faith

Euro and U.S DollarEURUSD

Introduction

How inflation affects the fair value P* of EURUSD

200D EMA (on jul-14) = 1.3643

Date CPI USD CPI EUR Iusd Ieur 1+(Iusd - Ieur) Forecast Actual Forecast error

Jul-14 237.34 118.31 1.3643

Aug-14 237.59 117.54 0.001053 -0.00651 1.00756167 1.3746 1.3422 0.0324

Sep-14 237.4 117.68 -0.0008 0.001191 0.99800922 1.3395 1.3117 0.0278

Oct-14 237.62 118.19 0.000927 0.004334 0.99659292 1.3072 1.2658 0.0414

Nov-14 237.75 118.12 0.000547 -0.00059 1.00113936 1.2672 1.2484 0.0188

Dec-14 237.06 117.91 -0.0029 -0.00178 0.99887564 1.2470 1.2466 0.0004

Jan-15 236.28 117.87 -0.00329 -0.00034 0.99704894 1.2429 1.2096 0.0333

Feb-15 234.67 116.03 -0.00681 -0.01561 1.00879647 1.2202 1.1311 0.0891

Mar-15 235.18 116.78 0.002173 0.006464 0.99570942 1.1262 1.1201 0.0061

Apr-15 235.74 118.11 0.002381 0.011389 0.99099222 1.1100 1.1078 0.0022

May-15 235.98 118.4 0.001018 0.002455 0.99856273 1.1062 1.121 -0.0148

Jun-15 237.03 118.66 0.00445 0.002196 1.00225358 1.1235 1.0952 0.0283

Valuation of EURUSD using PPP model

Data source : tradingeconomics.com

Valuation of EURUSD using PPP model (cont..)

Jul/14 Aug/14 Sep/14 Oct/14 Nov/14 Dec/14 Jan/15 Feb/15 Mar/15 Apr/15 May/15 Jun/151

1.05

1.1

1.15

1.2

1.25

1.3

1.35

1.4

EURUSD - PPP Forecast vs Actual rate

Forecast Actual

Greece crisis breaks down euro?

Could Greece crisis break WTI crude too?

Currency-Crude correlations

•You go long crude, you are effectively short the U.S. dollar.

•The U.S. dollar and crude oil have for many years been inversely correlated.

Disclaimer: Correlation is not causation

Inference

•Prediction of a currency is mainly based on major factors listed in this presentation.

•We have listed popular prediction models in this presentation.

•Currency valuation using PPP, IRP and other formulas are proven by economists and used widely for currency valuation.