YANG Yu School of Economics and Management Ningbo University of Technology Chapter 3 Foreign Exchange Determination and Forecasting

Brief Description ： In real life, exchange rates deviate from their parity values. Two methods are actively used to forecast exchange rates: economic analysis technical analysis. Central banks are active players on the foreign exchange market

Chapter 3: I.International Monetary Arrangements: 国际货币制度 II.The Empirical Evidence: 实证分析 III.Exchange Rate Forecasting: 汇率预测 3 - 3

Outline ： In this chapter we discuss: the evolution of international monetary arrangements the empirical evidence on parity relations various methods of exchange rate forecasting the use and performance of exchange rate forecasting use of forecasts for different types of investors

I.International Monetary Arrangements 3 - 5

Historical Perspective 3 - 6

The international monetary system evolved through three stages: Gold standard 金本位 Pegged exchange rate 钉住汇率制度 Freely floating exchange rates 浮动汇率制度 The current situation is one of floating exchange rates and in some parts of the world, a pegged exchange rate

Gold Standard After the mid-19th century, most countries decided that their currency would be exchangeable into gold bullion at a fixed parity. No treaty or agreement. To maintain equilibrium in the system, gold bullion was used to settle international transactions. One problem with this system was that the world money supply could grow only at the rate of new mining

Pegged Exchange Rates In 1944, the Bretton Woods agreement created the IMF and a system of pegged exchange rates. The objective was to create a stable system in which countries would have more autonomy in setting their own domestic policies. Also called the gold exchange standard, this system was distinguished by two characteristics: an enlargement of international reserves the design of stable but adjustable exchange rates. A fixed exchange rate, defended by central banks, offered great profit opportunities for speculation

The Current Situation: Floating and Pegged Exchange Rates Under the current system, the price of each currency is freely determined by market forces. Exchange rates fluctuate according to supply and demand. Some governments have linked their currency to others. In a currency board the exchange rate is fixed and the supply of domestic currency is fully backed by an equivalent amount of U.S. dollars

Question ： Has Hong Kong formally adopted a currency board?

Answer ： 7.75 – 7.85 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 Yuan

The Euro As of January 1, 1999 the euro was introduced for all official and inter-bank transactions, as well as for securities quotations and transactions. On January 1, 2002, euro bank notes were introduced and all former legacy currencies ceased to exist. The Euro countries in 2007 include: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain and Slovenia

II.The Empirical Evidence

The Empirical Evidence - Interest Rate Parity By arbitrage, IRP must hold for all major investment currencies (free / deregulated)  Some countries, especially developing ones, still impose various forms of capital controls and taxes that impede arbitrage.  Furthermore, some smaller currencies can be borrowed and lent only domestically, and domestic money markets are often subject to political risk and various types of costly regulations and controls.

The Empirical Evidence - International Fisher Relation. The International Fisher relation does not directly involve the exchange rate. The question raised is whether real interest rates are equal among countries Observe Exhibit 3.1 – real interest rates tend to move up and down together worldwide as a function of the world business cycle. Real rates went down in the early 2000s, but moved up in 2006.

Exhibit 3.1: Real Interest Rates: United States, Japan, and Germany, The Empirical Evidence - International Fisher Relation

 Various econometric tests suggest that real interest rates tend to move up and down together worldwide as a function of the world business cycle. Because national business cycles are not fully synchronized, however, significant differences in real interest rates can exist in any time period.  An investment strategy that takes advantage of such deviations from parity would be to invest in high-interest-rate currencies

The Empirical Evidence - Purchasing Power Parity PPP is considered a poor explanation for short term exchange rate movements, and hence for exchange rate volatility. However, PPP tends to holds quite well in the long run

Exhibit 3.2: Annual Comparison of Exchange Rate Movements, Inflation Differentials, and Interest Rate Differentials, The Empirical Evidence – Purchasing Power Parity

Exhibit 3.2: Annual Comparison of Exchange Rate Movements, Inflation Differentials, and Interest Rate Differentials, (cont’d) The Empirical Evidence – Purchasing Power Parity

There are several explanations of why PPP is not verified in the short run: There are several explanations of why PPP is not verified in the short run: The measurement of an inflation rate is questionable. Transfer costs, import taxes and restrictions and export subsidies may not allow arbitrage in the goods markets to restore PPP. Many factors other than inflation influence exchange rates

III.Exchange Rate Forecasting

Two methods are used to actively forecast exchange rates: Economic Analysis - fundamentalists Technical Analysis - technicians Economic analysis Economic analysis is the usual approach for assessing the fair value, present and future, of foreign exchange rates. Technical analysis Technical analysis may better explain short- run fluctuations in exchange rates  Summary: Economic analysis: long-run; Technical analysis: short-run.

The Importance of Exchange Rate Forecasting Arbitrage strategyShort-run investment strategyShort-run financing strategyLong-run financing strategyCapital budgeting decision ‘5 Needs’

The Econometric Approach  Two methods: Econometric Model & Subjective Approach.  Parameters for the econometric model are drawn from historical data. Current and expected values for causative variables are entered into the model, producing forecasts for exchange rates. Econometric Model has 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.  Sometimes, subjective approach (Delphi Method 德尔菲法 ) is generally more reliable

Technical Analysis price information Technical analysis of exchange rate bases predictions solely on price information. The analysis is technical in the sense that it does not rely on fundamental analysis of the underlying economic determinants, but only on extrapolations of past price trends. 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

Central Bank Intervention As 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

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

Summary of Exchange Rate Forecasting Technical analysis focuses on the short-run behavior of exchange rates. Whereas the economic approach is, by nature, better designed for long-run forecasts. A modeling of central bank intervention sometimes helps to understand the short-run behavior of foreign exchange rates