Theories of Foreign Exchange Determination
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Transcript of Theories of Foreign Exchange Determination
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1
Exchange Rate
Determination
Dr. C S Shylajan
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2
Introduction
An exchange rate is the relative price of onecurrency in terms of another
It influences allocation of resources within andacross countries
During the Bretton Woods era exchange rate wastreated as an exogenous variable
With the advent of floating rates in 1973, attention
once again shifted to determinants of exchangerates themselves
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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 withexchange rates?
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Some Fundamental Relationships T
here are two popular forms of Purchasing PowerParity theory.
Absolute form of PPP
& Relative form of PPP
Absolute form of PPP: Without internationalbarriers, consumers shift their demand to whereverprices are lower.
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Some Fundamental Relationships
Absolute Purchasing Power Parity (PPP)
The price levels in different countries determine theexchange rates of these countries currencies.
Exchange rates reflects the purchasing power of these
currencies.Rs.2000 for a basket of goods in India. Same basket costs $50 inUS. Then exchange rate between the Rupee and the dollar is2000/50 =Rs40/$
PURCHASING POWER PARITY : A DOLLAR IS WORTH 40 RUPEES
BECAUSE WHAT COSTS $1 IN US COSTS Rs.40 IN INDIA
Lawofone price: Price of a specified bundle of goodsand services, denominated in a given currency is sameeverywhere
St= Ph / P*f
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Some Fundamental Relationships
Stis the spot rate expressed as number of units ofhome currency per unit of foreign currency
Ptis the price index in the home country and Pt*is theprice index in the foreign country, both price indices withreference to a common base year
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Some Fundamental Relationships
Based on some assumptions Free movement of goods
No transportation cost
No transaction cost
No tariff or quota
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.IS IT EMPIRICALLY VALID?
THE ANSWER IS NO (why).
This "law"is not valid in practice because of transport costs,tariffs, quality differences etc.
Empirical testing also difficult. (composition of index is different,base year different)
Some Fundamental Relationships
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PURCHASING POWER PARITY
IN THIS FORM, IT MAY BE VALID OVER THE LONG RUN -
PERIODS OF 10-15 YEARS OR LONGER. NOT OF MUCHUSE IN FORECASTING EXCHANGE RATES FOR SHORTTERM PURPOSE
WITH DIFFERENCES IN PRODUCTIVITY GROWTH RATES,IT MAY NOT BE VALID EVEN IN THE WEAK FORM.
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PPP
PPP states that the exchange rate betweencurrencies of two countries is equal to the ratiobetween the prices of the two countries
In relative terms, PPP states that the exchangerate between the currencies of the two countrieswill adjust the changes in the inflation rate of thetwo countries.
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Relative Purchasing Power Parity
Percent change in exchange rate equals inflationdifferential% Change in Rupee/Dollar Exchange Rate
= Inflation Rate in India Inflation Rate in US
This will be true if St = k(Pt/P*t) k: Some constant
Faster inflation at home Home currencydepreciates 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 AGAINSTTHE YEN BY 2%. CHANGE IN EXCHANGE
RATEEQUALS INFLATION DIFFEENTIAL.
Some Fundamental Relationships
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Some Fundamental Relationships
According to relative form of PPP principle, thepercentage change in the spot exchange rateequals the difference in the inflation rates dividedby 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/$ ratewould 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%
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Some Fundamental Relationships
Real Exchange Rate is a measure ofexchange rate between two currencies adjustedfor relative purchasing power of the currencies
Re = Ste (Pd/Pf)
Ste denotes the nominal exchange rate at time twhile Pt
d and Ptfare price indices (say CPIs) in
countries A and B with reference to a common
base year. The real exchange rate Rt is alsoexpressed as an index with reference to thesame base year
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Interest Rate Parity (IRP)
H
ow is it possible to determine the rate ofexchange under a forward contract?
A forward exchange rate is the rate that is currentlypaid 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 iscalled the interest rate parity
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Interest Rate Parity
It states that the exchange rate between currenciesof two countries will be affected by their interestrate differential.
interest rate differential = exchange rate differential
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OTHER BASIC RELATIONSHIPS
COVERED INTEREST PARITY:
AMONG CONVERTIBLE CURRENCIES SPOT-FORWARDMARGIN EQUALS INTEREST RATE DIFFERENTIAL
INTEREST RATE DIFFERENTIAL EQUALS EXPECTEDCHANGE IN EXCHANGE RATE.
UIP NOT
FOUNDE
MPIRICALLY VALID (WH
Y?)
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Some Fundamental Relationships
If Relative PPP holds, RealE
xchange rate would remainconstant
The nominal and real exchange rates we have consideredare bilateral rates
The concept ofEffective Exchange Rate (EER) is utilizedto make multilateral comparisons
Nominal EER (NEER) captures movements in a currencyvis--vis a basket of currencies.
Real Effective Exchange Rate (REER) attempts to
capture changes in competitiveness vis-a-vis a group ofcompetitors in world markets rather than pair-wisecomparisons. It is NEER adjusted for inflation differencesbetween home and basket currency countries
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Some Fundamental Relationships
Purchasing Power Parity (PPP) as a Model ofExchange Rate Behaviour and Predictor
Absolute PPP does not hold in practice. Reasons aretransport 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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Some Fundamental Relationships
Fis
her Eff
ect Relationship between interest rate, inflation rate and
exchange rate
According to Fisher,
i = r + where i = nominal interest rate; r = real interest rate; and = inflation
rate
If money were free from all controls when transferred
internationally, the real rate of interest should be thesame in all countries (otherwise it will create anarbitrage opportunity)
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Some Fundamental Relationships
Combine UIP with relative PPP Let e denote the expected proportionate change in
the exchange rate
Take UIP
iA iB = e = TeA -TeB
iA -TeA = rA
iB -TeB = rB
This implies that with free capital flows and risk neutral
investors real interest rates are equalized between
A and B
-=Se
BA
ee
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Some Fundamental Relationships
Principle that a difference in nominal interest ratessupported by two countries currencies will cause anequal but opposite change in their spot exchange rates
Real interest rates are theoretically equal across
countries Any difference in interest ratesin two countriesmust be due to different expected ratesofinflation
A country that is experiencing inflation higher than
that ofanother country should see the value ofitscurrency fall
The exchange rate must be adjusted to reflect thischange in value.
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Some Fundamental Relationships
Reasonsfor Departure from Interest Rate Parity
Capital Controls:
restrictions on investing or borrowing abroad
restrictions on repatriation of investments made by
foreigners restrictions on conversion of currencies
Transaction Costs:
the bid-ask spread, the cost involved in conversion of
currencies; deposit lending spread, the difference between the
deposit and lending rates in the money market
Political Risks,Taxes, etc22
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Exchange Rate Forecasting
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Introduction
Many theories on the exchange rate determination Exchange rates (floating), like any price, is determined
by the forces of supply and demand
The problem is to correctly model all the factors that
influence the demand for and the supply of a currency Another complication is that foreign exchange is an
asset like equity shares
Like any such assets, its price at any time is heavilyinfluenced by expectations about future course of price
These expectations are very sensitive to economicevents, political developments, technologicaldevelopments, resource discoveries, etc.
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Exchange Rate Forecasting
Several factors affect the movements in exchangerates, often in a conflicting manner
Exchange rate theories can be used for exchangerate forecasting
But prediction of the exact level of future exchangerates is not possible
But forecasting of exchange rate is vital for important
players in the international markets and also for thespeculators.
Effectiveness of a forecasting tool accuracy andunbiasedness
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Forward Rate as a Predictor
Forward rate, an unbiased predictor of futurespot rate provided,
Market should be competitive, the currencies
should be freely floating However, no evidence that the forward rates
as accurate predictors of future rates
Reason: future spot rates are affected by allthe expected and unexpected developments
The unexpected factors cannot be factored inthe forward rates
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Demand Supply Approach
Exchange rates can be forecasted by analyzing thefactors that affect the demand and supply of a currency
These factors are listed out in the BoP account.Therefore, this approach also known as balance-of-
payments approach
Exchange rate is the equilibrium price that equatesthese demands and supplies
Different models of exchange rates differ in theemphasis they put on the different components ofdemand for and supply of a currency
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Demand Supply Approach
Demand for currency A arisesfrom:
1. Rest of the World (ROW) purchasing goods andservices from country A and making payments in Ascurrency (including payments for factor services) ormaking unilateral transfers to residents of A
2. ROW wishing to hold financial assets denominated incurrency A; ROW wishing to make direct investments in A
Supply ofcurrency A arisesfrom:
1. Residents of country A wishing to buy goods andservices from ROW or make unilateral transfers to ROW
2. Residents of country A wishing to make direct andportfolio investments abroad including central bank of A
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Demand Supply Approach
Simplest view of exchange rate focuses on demand forand supply of foreign exchange arising out of importsand exports (known as Flow Models)
According to Flow Models, as the home currency
depreciates, imports become more expensive whileexports become cheaper in terms of foreign currency
Demand for imports falls while for exports expands
Supply of foreign currency rises while demand shrinks,
putting upward pressure on the home currency
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Demand Supply Approach
Suppose, demand for imports rises (due to fastereconomic growth at home, etc), other thingsremaining the same, the home currency willdepreciate
Alternatively, exports shrink (due to supplyproblems in export industries, economic slow downin buyer country, competition, etc), home currencydepreciate
Conversely, when demand for imports shrinks orthat for exports rises, the home currencyappreciate
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Demand Supply Approach
Thus, in this approach the exchange rate isinfluenced by the forces affecting demand andsupply of imports and exports
These include fiscal and monetary policies thataffect the level of economic activity, productivitychanges, changes in consumer preferences, tariffsand trade barriers, etc
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Demand Supply Approach
D S E: Equilibrium Exchange
Rate
Exchange
Rate
Rupee/$
E
S
D
No. of Dollars
Figure 1
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Demand Supply Approach
This theory says, any change in the value of currencyis only an instrument to correct the temporary
imbalance in the systemAt 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 accountbalance may worsen. Why?
J-curve effect
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Demand Supply Approach
Some times, while thephysical volume of our exportsmay increase, but the amount of foreign currencyearned from those exports may decrease.
This happens due to low price elasticity of demand for
exports. When both imports and exports are price inelastic inthe short run but price elastic in the long run, volume ofexports and imports do not immediately respond to thechange in relative prices of exports and imports,
caused by depreciation of currency. This leads todeterioration in the Balance of Trade. Then currencydepreciates further.-J Curve
People take some time to adjust to the changes in
relative prices (time lag)34
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Demand Supply Approach
Major problem with the model is its total neglect ofcapital account
Mundell-Fleming model attempts to correct this byincluding capital flows.
Capital flows dependent on interest rate differentialbetween home and the ROW
Current account balance depends upon the NationalIncome and exchange rate;
Capital account balance depends upon the interestrate differential
National income and interest rates are influenced bythe fiscal and monetary policy.
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Asset Market Models
The Monetary ModelAccording to this approach, exchange rates are
essentially monetary phenomena.
Assumptions:
There is only one asset viz. money. Residents ofa country hold only that countrys money.
Purchasing Power Parity holds (an increase in
countrys price level results in the depreciation ofthat countrys currency and vice versa)
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The Monetary Model
The core of the model is the assertion thatdomestic residents, when faced with a discrepancybetween the stock of (domestic) money they wishto hold and the actual stock of money created by
the monetary authority, will attempt to correct it byrunning a balance of payments deficit or surplus
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The Monetary Model Suppose, real GNP of a country increases, resulting in an
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 pricelevel
A reduction in price level causes appreciation of thecurrency
Thus, increase in real GNP brings an appreciation of thecurrency
Suppose, there is excess supply of money, resulting inincreased demand for domestic as well as foreign goods
The domestic price level rises and the exchange ratedepreciates
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The Monetary Model
Thus, the monetary approach predicts that strongeconomic growth coupled with moderate growth inmoney supply and credit will result in a strong and
stable currency, while excessive credit creation,especially when the economy is not growingrapidly, will cause a fall in currency
Is it true with Rupee appreciation and depreciationepisodes?
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The Monetary Model
This model also predicts that an increase in homecountry interest rate, given other things, will lead to adepreciation of a home currency
Why?
This go against the common notion (that higherinterest rate leads to higher capital inflows)
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i i i
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Expectations, News.Technical analysis
etc
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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Structural Models of Exchange Rate
Any new pertinent information alters traders' viewsregarding future course of prices and is immediatelyreflected in the current price
Importance of expectations and unanticipated events
Technical Analysis
Economic variables are ignored.
Using historical data
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Summary-Exchange Rate Forecasting
Exchange rate forecasts are an important input into a
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 monetaristmodel Pure forecasting models" that includes time series
methods and "technical analysis"
Recent developments in modeling and predictingfinancial time series have applied mathematicaltools.
Composite Forecasts A combination of differentforecasts
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Exchange Rate Forecasting
The
value
ofafo
recast depend
sup
on
How much does the forecast contribute to betterdecision making given that the firm has its ownsources 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 doconsiderably better than forward rate in predicting
direction and magnitude of movement
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The Exchange Rate of the Rupee
Central Bank has still an important role
RBI acts to moderate excessive fluctuations andprevent panics.
Behavior of the spot rate in India is largely governed bytrade related flows since the capital account continuesto be strictly controlled
In the very short run, portfolio decisions of FIIs cangenerate significant volatility in the rupee exchangerate as we have seen recently.
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