International Investment 2
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Transcript of International Investment 2
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.