ECW2721 Lecture W8 Forex
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Transcript of ECW2721 Lecture W8 Forex
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WEEK 8
Chapter 9
TheDeterminants of
Exchange Rates
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Belarus National Bank has announced 56% devaluation of its national currency theBelarusian rouble, thus evoking panic amongst Belarus residents, hurriedly stocking upfood and other goods.
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Learning Objectives
To understand the various approaches to forecasting the exchange
rates
To understand the strengths and limitations of each approach
To understand exchange rate movements over the short and long
term.
Reading:
Australian edition (Chapter 9)Global edition (Chapter 9)
Week 8 4
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Foreign Exchange RateDetermination
Exchange rate determination is complex. Exhibit 9.1 provides an overview of the many
determinants of exchange rates.
This road map is first organized by the three major
schools of thought (parity conditions, balance ofpayments approach, asset market approach), andsecondly by the individual drivers within thoseapproaches.
These are not competingtheories but rathercomplementarytheories.
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Foreign Exchange RateDetermination
Without the depth and breadth of the variousapproaches combined, our ability to capture thecomplexity of the global market for currencies islost.
In addition to gaining an understanding of the basic
theories, it is equally important to gain a workingknowledge of:
the complexities of international political economy;
societal and economic infrastructures; and,
random political, economic, or social events that affect theexchange rate markets.
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Exhibit 9.1 The Determinants ofForeign Exchange Rates
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Exchange Rate Determination:The Theoretical Thread
The previous exhibit, with its tripartitecategorization of exchange rate theory is agood start but in our humble opinion isnot robust enough to capture the multitudeof theories and approaches.
Therefore, in the following slides, we willintroduce several additional streams ofthought.
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Exchange Rate Determination:The Theoretical Thread
The theory ofpurchasing power parityis themost widely accepted theory of all exchangerate determination theories: The long-run equilibrium exchange rate is
determined by the ratio of domestic prices (Pd)relative to foreign prices (Pf).
Most exchange rate determination theories havePPP elements embedded within theirframeworks.
PPP calculations and forecasts are howeverplagued with structural differences acrosscountries and significant data challenges inestimation.
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Exchange Rate Determination:The Theoretical Thread
The balance of payments approachis thesecond most utilized theoretical approach inexchange rate determination: The basic approach argues that the equilibrium
exchange rate is found when currency flows matchup vis--vis current and financial account activities.
CA = -FA or CA = FA
This framework has wide appeal as BOP transactiondata is readily available and widely reported.
Critics may argue that this theory does not takeinto account stocks of money or financial assets.
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Exchange Rate Determination: TheTheoretical Thread
The monetary approach in its simplest formstates that the exchange rate is determinedby the supply and demand for nationalmonetary stocks, as well as the expected
future levels and rates of growth ofmonetary stocks.
Other financial assets, such as bonds arenot considered relevant for exchange rate
determination, as both domestic and foreignbonds are viewed as perfect substitutes.
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Exchange Rate Determination: TheTheoretical Thread
The asset market approachargues thatexchange rates are determined by thesupply and demand for a wide variety offinancial assets: Shifts in the supply and demand for financial
assets alter exchange rates.
Changes in monetary and fiscal policy alterexpected returns and perceived relative risks offinancial assets, which in turn alter exchangerates.
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Exchange Rate Determination: TheTheoretical Thread
The forecasting inadequacies of fundamentaltheories has led to the growth andpopularity of technical analysis, the beliefthat the study of past price behaviorprovides insights into future pricemovements.
The primary assumption is that any market
driven price (i.e. exchange rates) followstrends.
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The Asset Market Approachto Forecasting
The asset market approachassumes that whetherforeigners are willing to hold claims in monetary formdepends on an extensive set of investment considerationsor drivers (among others):
Relative real interest rates
Prospects for economic growth Capital market liquidity
A countrys economic and social infrastructure
Political safety
Corporate governance practices Contagion (spread of a crisis within a region)
Speculation
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The Asset Market Approachto Forecasting
Foreign investors are willing to holdsecurities and undertake foreign directinvestment in highly developed countriesbased primarily on relative real interest
rates and the outlook for economic growthand profitability.
The asset market approach is alsoapplicable to emerging markets; however in
these cases, a number of additionalvariables contribute to exchange ratedetermination (previous slide).
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Currency Market Intervention(Why?)
Foreign currency intervention is the activemanagement, manipulation, or interventionin the markets valuation of a countryscurrency.
Why Intervene? Fight inflation (strong currency)
Fight slow economic growth (weak currency)
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Currency Market Intervention(How?)
Methods of intervention are determined bymagnitude of a countrys economy,magnitude of trading in its currency, andthe countrys financial market development
Direct Intervention the active buying and selling of the domestic
currency against foreign currencies
If the goal is to increase the value, then thecentral bank buys its own currency
If the goal is to decrease the value, then thecentral bank sells its own currency
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Currency Market Intervention(How?)
If bank intervention is insufficient, thencoordinated intervention may be used wherebyseveral central banks agree on a strategy toincrease or decrease a currency value.
Indirect Intervention is the alteration of economicor financial fundamentals which are thought to bedrivers of capital to flow in and out of specificcurrencies. Increase real rates to strengthen a currency
Decrease real rates to weaken a currency
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Currency Market Intervention(How?)
Capital Controls are restrictions of access to foreigncurrency by the government by limiting the exchange ofdomestic currency for foreign currency.
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Disequilibrium: Exchange Ratesin Emerging Markets
Although the three different schools of thought on exchangerate determination (parity conditions, balance of paymentsapproach, asset approach) make understanding exchangerates appear to be straightforward, that it rarely the case.
The large and liquid capital and currency markets follow manyof the principles outlined so far relatively well in the medium
to long term. The smaller and less liquid markets, however, frequently
demonstrate behaviors that seemingly contradict the theory.
The problem lies not in the theory, but in the relevance of theassumptions underlying the theory.
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Illustrative Case: The Asian Crisis
The roots of the Asian currency crisis extendedfrom a fundamental change in the economics of theregion, the transition of many Asian nations frombeing net exporters to net importers.
The most visible roots of the crisis were the excess
capital inflows into Thailand in 1996 and early1997.
As the investment bubble expanded, somemarket participants questioned the ability of theeconomy to repay the rising amount of debt and
the Thai bhat came under attack.
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Illustrative Case: The Asian Crisis
The Thai government intervened directly (usingup precious hard currency reserves) andindirectly by raising interest rates in support ofthe currency.
Soon thereafter, the Thai investment marketsground to a halt and the Thai central bankallowed the bhat to float.
The bhat fell dramatically (see Exhibit 9.2) andsoon other Asian currencies (Philippine peso,Malaysian ringgit and the Indonesian rupiah)came under speculative attack.
E hibi 9 2 Th Th i B h d h
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Exhibit 9.2 The Thai Baht and theAsian Crisis
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Sirivat Sandwich
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Illustrative Case: The Asian Crisis
The Asian economic crisis (which was muchmore than just a currency collapse) hadmany roots besides traditional balance ofpayments difficulties:
Corporate socialism
Corporate governance
Banking liquidity and management
What started as a currency crisis became aregion-wide recession.
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June 1967: The old Sterling-
linked Malayan/Straits Dollar
was replaced by separate
dollars of Malaysia (RM),
Singapore and Brunei.
February 1973: Following the
U.S. Dollar devaluation, the
RM was realigned to
M$2.5376 per U.S. dollar,
based on the currency's
unchanged gold content.
June 1973: Malaysia placed
the Effective rate for her
dollar on a controlled, floating
basis. Bank Negara Malaysia
intervened in order tomaintain relative stability in
the value of Ringgit in relation
to the basket of currencies.
2 September 1998: The exchange rate was no
longer determined by demand and supply. The
Central Bank announced that the exchange rate of
the Ringgit would be pegged against the U.S.
Dollar at RM3.80 = $1.
In July 2005, the Ringgit no longer pegged to the
US dollar, but shifted to a managed float system.
Malaysia Exchange Rates
(RM/$US)
ll i C
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Illustrative Case:The Russian Crisis of 1998
Debt service had become a real problem Capital flight was taking place
The ruble traded via a managed float that hadbeen continually adjusted since 1996
August 7, 1998 began the August Crash with theannouncement that currency reserves had fallen$800M in the last week
August 10, the Russian stock market falls 5%
August 17, Russia announces the ruble will beallowed to devalue by 34%
Exhibit 9.3 illustrates the rubles decline
E hibit 9 3 Th F ll f th R i
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Exhibit 9.3 The Fall of the RussianRuble
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Technical Analysis
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Forecasting in Practice
Technical analysts, traditionally referred to as chartists, focuson price and volume data to determine past trends that areexpected to continue into the future. really just studies supply and demand in a market
attempts to understand the emotions in the market by studying themarket itself.
The single most important element of technical analysis is thatfuture exchange rates are based on the current exchangerate.
Exchange rate movements can be subdivided into threeperiods:
Day-to-day
Short-term (several days to several months)
Long-term
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Forecasting in Practice
The longer the time horizon of the forecast, themore inaccurate the forecast is likely to be.
Whereas forecasting for the long run mustdepend on the economic fundamentals of
exchange rate determination, many of theforecast needs of the firm are short to mediumterm in their time horizon and can be addressedwith less theoretical approaches.
Exhibit 9.5 summarizes the various forecastingperiods, regimes, and the authors suggestedmethodologies.
Exhibit 9 5 Exchange Rate
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Exhibit 9.5 Exchange RateForecasting in Practice
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Forecasting: What to Think?
It appears, from decades of theoretical andempirical studies, that exchange rates doadhere to the fundamental principles andtheories previously outlined.
Fundamentals do apply in the long term
There is, therefore, something of afundamental equilibrium pathfor a
currencys value.
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Forecasting: What to Think?
It also seems that in the short term, a variety ofrandom events, institutional frictions, and technicalfactors may cause currency values to deviatesignificantly from their long-term fundamentalpath.
This behavior is sometimes referred to as noise. Therefore, we might expect deviations from the
long-term path not only to occur, but to occur withsome regularity and relative longevity.
Exhibit 9.6 illustrates the synthesis of forecastingthought.
Exhibit 9.7 shows the dynamics of exchange ratemanipulation.
Exhibit 9 6 Short Term Noise
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Exhibit 9.6 Short-Term NoiseVersus Long-Term Trends
Exhibit 9 7 Exchange Rate
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Exhibit 9.7 Exchange RateDynamics: Overshooting
What Determines the Exchange Rate: Economic
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gFactors or Market Sentiment?Gregory P. Hopperhttp://wps.aw.com/wps/media/objects/744/761963/rdg39.pdf