LUBS5052 International Investment

Charlie X. CaiWWW. CharlieXCai.info

Exchange Rate Determination & Forecasting

Session 2

Agenda

The international parity relationsThe determinants of exchange rates in the short run & the long runThe Exchange Rate RegimesMethodologies and models employed in exchange rate forecasting.

1. The international parity relations

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Parity Relations

The purchasing power parity relation, linking spot exchange rates and inflation.The International Fisher relation, linking interest rates and expected inflation.The uncovered interest rate parity relation, linking spot exchange rates, expected exchange rates and interest rates.The foreign exchange expectation relation, linking forward exchange rates and expected spot exchange rates.See Handout 1, No. 1

Summary of Parity Relations

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Exhibit 2.3: International Parity Relations Linear Approximation

PPP

International Fisher relation

Interest rate parity

Foreign exchange

expectation

PPP

Poor explanation of short term exchange rates: Implies real returns for investors of different countries DO differ.– Definition of inflation– Transfer costs, import taxes, export subsidies

Recent research shows that exchange rates revert to PPP values in the long run (e.g. Grossman & Rogoff (1995)) - Large deviations from PPP cannot continue forever

Intl. Fisher Relation

Earlier studies found support for the model for major currencies (e.g. Kane & Rosenthal 1974 – 1979)Later studies (post 1979) indicate that real rates variable over time & across countriesProblems with measuring real rate since requires measure of expected inflation.

FOREX expectations

Regression (expected) ex. rate movement against forward discount premium (or equivalently interest rate differential) observed at start of period:– [(S(t+1) – St) / St] = + [(Ft - S0)/S0] +

Problems measuring E(S1), and in practice ex post S1 substituted.R2 usually low and sometimes negative (it should be 1)Explanations:– Exchange rates are unpredictable– A time varying risk premium should be included in the

relationship.

Interest rate parity

Where markets are free & unregulated this relation MUST hold, within transaction costsFor certain currencies deviations from interest rate parity can be quite large:– Many developing countries impose various forms of capital

controls & taxes which impede arbitrage– Some smaller currencies can only be borrowed or lent

domestically & carry considerable political risk

Lessons from international money markets

Exchange rates do not neutralise inflation differentials in real termsExchange rates do not correct interest rate differences between two currenciesInternational investors are faced with currency risk, although over the long run mean reversion reduces this risk.Portfolio performance can be improved by correctly forecasting exchange rates.International asset pricing models need to incorporate exchange risk

2. Determining exchange rates

What affects exchange rates?

Differences in national inflation ratesChanges in real interest ratesDifferences in economic performanceChanges in investment climateGovernment monetary policyGovernment fiscal policy

Value based on absolute PPP

Compare prices of goods in two countriesDoes the exchange rate conform to absolute PPP, or is it undervalued or overvalued?Example:– A Big Mac costs 2600 wons in Seoul & 2.56$ in the US. The current

exchange rate is 1,474 wons/$. Is the South Korean currency under/over valued relative to the USD?

– Exchange rate implied by Big Mac assuming law of one price = 2600wons/2.56$ or 1015.625wons/1$. The won is undervalued by (1015.625/1474) – 1% = -31%

– See Exhibit 3.1, Solnik, page 61

Value based on relative PPP

Method:– Select an inflation index for each country– Select an historical period for which to compute the long run PPP– Determine the fundamental value of the exchange rate and any

under/over valuation

Problems:– Selecting an inflation index– The base date selected will give different conclusions

Summary of PPP approach

PPP should help explain future movements in exchange rateExchange rates can become very misaligned & stay soAdditional models are required to determine exchange rate movements

Balance of Payments Approach

See No. 1, Handout 2.1. Trade flows under capital restrictions:– (a) Is there a trade balance deficit?– (b) How will imports & exports react to an exchange rate

adjustment?

2. Financial flows:– Do financial flows cover any current account deficit?

3. Web exercise: – Source of information on BOP

The Asset Market Approach

Exchange rates are asset prices traded in an efficient market.The exchange rate is determined by the relative willingness to hold each currencyThe exchange rate is determined by expectations about the future, and not by current trade flows.Requires that news that should affect ex. rate be specified and its influence be quantified a priori.Short term viewNews traders Sites:

3. Exchange Rate Regimes

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Exchange Rate Regimes

Historically, there have been three different regimes:– Flexible (or Floating) Exchange Rates– Fixed Exchange Rates– Pegged Exchange Rates

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Flexible (Floating) Exchange Rate Regime

One in which the exchange rate between two currencies fluctuates freely in the foreign exchange market.Advantage– The exchange rate is a market-determined price that reflects

economic fundamentals at each point in time.– Governments are free to adopt independent domestic

monetary and fiscal policies.

Disadvantage– Quite volatile exchange rates.

Fixed Exchange Rate Regime

One in which the exchange rate between two currencies remains fixed at a preset level, known as official parity.Advantages:– Eliminates exchange rate risk, at least in the short run.– Brings discipline to government policies.

Disadvantages:– Deprives the country of any monetary independence.– Also constrains country’s fiscal policy.– Its long-term credibility

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Currency Board

Today some countries try to maintain a fixed exchange rate regime against the dollar or euro.This is done through a “currency board”The supply of home currency is fully backed by an equivalent amount of that major currency.

Question

Has Hong Kong formally adopted a currency board?

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Answer

Hong Kong did not formally adopt a currency board. Instead, it announced a total commitment to maintain a parity of the HK dollar with the U.S. dollar within the band of 7.75 – 7.85 HK$/U.S$. The Hong Kong Monetary Authority stands ready to use its reserves to defend the fixed rate, despite pressures brought by the appreciation of the Chinese RMB (yuan).

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Pegged Exchange Rate Regime

Characterized as a compromise between a flexible and a fixed exchange rate.– The exchange rate is allowed to fluctuate within a (small)

band around a target exchange rate (“peg”) and the target exchange rate is periodically revised to reflect changes in economic fundamentals.

Advantages– Reduces exchange rate volatility in the short run.– Also encourages monetary discipline for the home country.

Disadvantage– Can induce destabilizing speculation.

Problems with pegged exchange rates

In a pegged system the exchange rate remains constant provided credibility & confidence in fundamentals maintained.Where adjustments do occur they tend to be large, since the country has been committed to defending a preset exchange rate level.In the long run the exchange rate must reflect fundamentals.

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International Monetary Arrangements

The international monetary system evolved through three stages:– Gold standard– Pegged exchange rate– Freely floating exchange rates

The current situation is one of floating exchange rates and in some parts of the world, a pegged exchange rate.

Currency Crises

– A widening current a/c deficit used to be offset by a capital a/c surplus (under a booming economy), but prospects for growth less thus investment less

– Country draws on its reserves & sets off speculation– Interest rates are raised to attract capital but high interest rates

hurt the economy causing further slow down in growth– Capital control measures are put in place. The IMF provides

additional reserves– Markets pessimistic and devaluation is required– Currency devaluation may cause increased inflation and lead to

further depreciation.

4. Forecasting methodologies & models

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Exchange Rate Forecasting

Two methods are used to actively forecast exchange rates:– Economic Analysis– Technical Analysis

Economic analysis is the usual approach for assessing the fair value, present and future, of foreign exchange rates.However, it is often argued that technical analysis may better explain short-run fluctuations in exchange rates.

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The Econometric Approach

Econometric models make it feasible to take complex correlations between variables into account explicitly.Parameters for the model are drawn from historical data.Current and expected values for causative variables are entered into the model, producing forecasts for exchange rates.

Forecasting Models

Traditional– Time varying expected return: ARIMA– Time varying expected return: Information variables– Time varying variances: GARCH

Non traditional– Chaos Theory– Artificial intelligence, expert systems, neural networks– See Solnik, Chapter 3, Appendix

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The Econometric Approach

These models have two drawbacks:– most rely on predictions for certain key variables (money

supply, interest rates) that are not easy to forecast.– The structural correlation estimated by the parameters of

the equation can change over time.

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Technical Analysis

Bases predictions solely on price information.Technical analysis looks for the repetition of specific price patterns.Once the start of such a pattern has been detected, it automatically suggests what the short-run behavior of an exchange rate will be.Technical analysis has long been applied to commodity and stock markets.The application to the foreign exchange market is a more recent phenomenon.

Technical Analysis

Moving averages– The aim is to smooth erratic daily swings of exchange

rates in order to signal major trends.

Filter rule– buy signals when an exchange rate rises X percent (the

filter) above its most recent trough– sell signals when it falls X percent below the previous

peak.

Index of market momentum

Central Bank Intervention

Major players in the foreign exchange markets.Their motives are somewhat different from those of most other market participants. Some central banks are renowned for the active management of their foreign currency reserves, but most do not attempt to profit from trading.Central banks try to implement the monetary policy and exchange rate targets defined by their monetary authorities.

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Exhibit 3.5 An Example of the Impact of News about Central Bank Intervention

Performance of Forecasts

Different measures of forecasting ability can be used and the track record of forecasters shows the difficulty of the task.The type of method used to forecast exchange rates depends on the user’s motivation.A currency hedge focuses on short term movements, while an international asset allocator cares about long-term prospects.

Use of Forecasts

The corporate treasurer who manages a complex international position with daily cash flows and adjustments in his foreign exposure can respond readily to technical analysis recommendations. This is not the case for money managers who tend to use economic models for their asset allocation.Money managers use technical analysis of currencies mainly for timing their investment sales and purchases or for currency-hedging decisions using derivatives.

Exercises from Solnik

Chapter 2: Qus 1, 2, 4, 7, 8, 9, 12 ,14Chapter 3: Qus. 1, 9, 2, 8, 10

Web Exercise

PPP between US$ and GBP– 1980-2006– 1980-1990– 1990-2000– 2000-2006

Balance of Payments– Source of information. Latest number for US, UK, Euro, JP,

and your home country.