Chapter1: Nature and background of the study

Chapter1: Nature and background of the study

1.1 Introduction

Globalisation has resulted in a new configuration of world trade, production and finance, and has had a direct impact on international competitiveness, trade and financial flows and relative prices. In addition, it has brought about changes in the dynamic interactions of economic variables, including possibly the way changes in the exchange rate affect the economy. This applies to Vietnam as well. An exchange rate is essentially what its name implies: it is the rate at which one would need to exchange ones currency for the currency of another country. These rates of exchange can change at a moments notice (or less) in currency markets where the currencies are freely floating. Thus, the exchange rate is aconversion factor, a multiplier or a ratio, depending on the direction of conversion. Exchange rate is undoubtedly important because it allows for the conversion of one country's currency into that of another, thereby facilitating international trade for purchases of goods and services and/or transfer of funds between countries, and it allows price comparison of similar goods in different countries. In general, the price difference between similar goods determines which goods are traded and where they are shipped or sourced. It is safe to say that the exchange rate is a significant factor influencing the competitiveness of agricultural commodities and the profitability of farming enterprises. Therefore, the purpose of this research is to point out which factors play a significant role on the result of the the exchange rate. Throughout this research, we look at some main factors which affect the exchange rate with data gathered mainly from secondary research.1.2Overview of exchange rate in Vietnam

In order to put the overall discussion into perspective, this part provides a general overview of the major points in the exchange rate in Vietnam in recent years. As observed and recorded, The US Dollar increased to 21680 Vietnamese Dong in May from 21575 in April of 2015. The Vietnamese Dong averaged 18163.60 from 2003 until 2015, reaching an all time high of 21680 in May of 2015 and a record low of 15002 in December of 2003.

1.3Rational for the study

The foregoing discussion implies the fact that there has been a fluctuation in the exchange rate in Vietnam throughout the period from 2003 to 2015. Vietnam economy experiences important turning points in 2007 when became the official members of WTO. Taking this under consideration, conducting the research on this period enables us to capture the effects of economic elements on the amount of FDI more precisely.

1.4 Assumptions

In order to apply ordinary least squares method which is the one utilized in this paper, 10 classical assumptions and 1 optional assumption must be satisfied; however in this research, we focus on detecting and solving the violation of following assumptions namely: multicollinearity, heteroscedasticity, autocorrelation and normal distribution of residual to make sure that our model is applicable.

Chapter2: Literature review

2.1Theories of exchange rate2.1.1 The Purchasing Power Parity or PPP happens to be one of the most significant approaches to determine exchange rate. PPP is primarily based on the Law of One Price. However, this law is based on the assumption that identical goods are sold at equal prices. It is a flow model of the balance of payment. This law lays down that exchange rate of currencies have to compensate for the differences in prices of goods. The Relative PPP approach continues to be applied till date. This approach lays down the fact the exchange rate has to compensate for the difference in inflation rate. PPP is not a very reliable determinant since changes in technology, commercial policies, labor force and tastes change the national productivity, which in turn changes the real exchange rate.

2.1.2 The Balance of Payment Approach depends on the assumption that there exists an exchange rate and there exists internal and external equilibrium. The internal equilibrium is based on the assumption that there is full employment. The external equilibrium is the equilibrium in the balance of payments. This theory is more dependable as it can explain permanent deviations in PPP. This approach offers guidance on short term ups and downs. There are certain disadvantages of this approach. The model does not inform about the exact rate of unemployment. Next, the exchange rate does not maintain its consistency in accordance with the external accounts.

2.1.3 Monetary and Portfolio Approach is an approach in which the prices of various domestic and foreign assets are decided. The agent is given a portfolio choice of various assets. The instruments, which are either money or bonds, have an expected return that could be invested. This investment opportunity determines the exchange rate. The opportunity of investment arises when the expected depreciation does not compensate the difference in exchange rates.

2.2Prior research Tran Phuc Nguyen and Duc-Tho Nguyen Griffith Business School (AFE) Griffith University: Vietnams exchange rate policy and implications for its foreign exchange market, 1986-2009 Jean-Pascal Bassino and Hironobu Nakagawa, Paul Valry University: Exchange rates and exchange rate policies in Vietnam under French rule, 1878-1945 Tran-Phuc Nguyen, D.T. Nguyen, Jen Je Su and Tarlok Singh: Shifts in exchange rate regime and inflation persistence in Vietnam, 1992-20102.3Model specification

With the knowledge getting from the prior researches and by applying the econometrics theory to examine the effect of each factor, we choose our model as below:

In which the variables are:ER: Exchange rate

VNIR: Vietnam Interest rate

USIR: US Interest rate

MS: Money supply

TRADE: Trade per GDP

D: Dummy variable. D = 0 if the time frame was from 2007 to 2013 and D = 1 if it doesnt fall in this time frame

2.3.1 Dependent variableFor this research, we choose the exchange rate as the dependent variable. With the fundamental knowledge getting from some prior researches, we analyze effects of the following factors on the exchange rate: Vietnam interest rate, US interest rate, money supply and trade per GDP.

2.3.2Independent variables

2.3.2.1 Vietnam interest rate

Interest rates and exchange rates are highly correlated. By manipulating interest rates,central banksexert influence exchange rates, and changing interest rates impact currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates - that is, lower interest rates tend to decrease exchange rate. 2.3.2.4 US interest rate

Like Vietnamese interest rate, US interest rate also plays a significant role in affecting the exchange rate. Hence, we choose US interest rate, along with Vietnam interest rate as independent variables to study if these two factors can greatly affect the dependent variable or not.

2.3.2.3 Money supply

From what we have learned in Microeconomics, in many circumstances an increase in the money supply could lead to a depreciation in the exchange rate. Thats why money supply is the 3rd independent variable we would like to use in order to research more about the relationship of it with the exchange rate and how it can affect the exchange rate in the process.2.3.2.2 Trade per GDP

A ratio comparing export prices to import prices, the terms of trade is related to current accounts and thebalance of payments. If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater demand for the country's exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country's currency (and an increase in the currency's value). If the price of exports rises by a smaller rate than that of its imports, the currency's value will decrease in relations to its trading partners. Therefore, trade per GDP is chose as another independentvariable.

2.3.3 Dummy variableApart from four independent variables mentioned above, we choose one dummy variable (D) which is the time frame. D = 0 if the time frame was from 2007 to 2013 and D = 1 if it doesnt fall in this time frame. The reason we decided to use it as dummy variable is because Vietnam economy experiences important turning points in 2007 when became the official members of WTO.https://www.ecb.europa.eu/pub/pdf/scpops/ecbocp94.pdfhttps://edis.ifas.ufl.edu/fe546http://www.tradingeconomics.com/vietnam/currencyhttp://www.investopedia.com/articles/basics/04/050704.asphttp://www.economicshelp.org/blog/11550/currency/money-supply-and-the-exchange-rate/