Market Determinants of Exchange Rates

Why Study Exchange Rates? To understand the economic environment Forecasting for planning purposes To understand exposure to currency risk Financial impact of exchange rate move varies With the nature of the asset/liability With the cause of the move

Outline: Exchange Rate Determination Role of Government Market Forces Real economic effects Monetary effects

Market Forces: Real Effects

To focus on real effects assume: No currency market intervention No inflation in either country

Real exchange rates are determined by real economic events affecting supply and demand for the currencies

Balance of Payment Accounts Components: Current Account - Goods and Services Financial Account - Investment Reserve Account - Government Reserves

Factors Affecting Trade (Current Account) Real price “shocks” Example: Oil price shock Government policy change Tariff/ Trade policy

Factors Affecting Investment (Financial Account) Real return “shocks” example: turn of business cycle Government policy (affecting real returns) tax policy labor law Perceived risk war, political risk

Conclusions about real effects Changes in any of these real factors Shifts supply or demand for currency Affects exchange rate Of interest to currency forecasters Is also reflected in balance of payments data Thus BOP data of interest to forecasters

Why the Balance of Payment Balances Definitions Y = output C = consumption I = investment S = savings X = exports M = imports

Why the BOP Balances (2) Definitions - national income accounts Y = C + I + (X - M) S = Y - C Definitions - BOP accounts Current Account = X - M Capital Account = I - S

Why the BOP balances (3) S - I = Y - C - I = (X - M) Thus definition of savings definition national income accounts Thus 0 = (X - M) + (I - S) current account + capital account = 0

Because BOP must balance Don’t just consider whether the current account is negative (= financial account is positive) Think about the composition of the financial account “hot money” v. long-term investments

Market Forces: Monetary Effects

Purchasing Power Parity Logic: “arbitrage” in market for goods

Definitions: PPP Absolute Purchasing Power Parity The purchasing power of the dollar is the same everywhere in the world Relative Purchasing Power Parity Exchange rates move to offset differences in rates of inflation.

How well does PPP predict in practice? Absolute PPP – Not at all Relative PPP Works well In the long run When differences in inflation are dramatic Works much less well in the short run

Real Exchange Rate Definition: Exchange rate after removing the effects of inflation If Purchasing Power Parity holds, then real exchange rates never change

Currency Exposure

Definitions Nominal Asset - Value defined as a stated amount of some currency Example: A bond at maturity Real Asset - Value defined by market price of something tangible Example: Real estate; inventory

An Important Distinction The impact of exchange rate movements differ depending on whether the exchange rate event is real or monetary whether the item affected is real or nominal Restated: The nature of exchange rate exposure differs for real and nominal assets

Example Real Asset Rb value x exchange = $ value before Rb 100,000 .04 ($/Rb) $ 4,000 Nominal Asset Rb value x exchange = $ value Now suppose we have 100% inflation in Russia No inflation in the U.S.

Example: 100% Russian Inflation Real Asset Rb value x exchange = $ value before Rb 100,000 .04 ($/Rb) $ 4,000 after(mon.) Rb 200,000 .02 ($/Rb) $ 4,000 Nominal Asset Rb value x exchange = $ value after(mon.) Rb 100,000 .02 ($/Rb) $ 2,000

Example continued Real event In the previous example (monetary event) the real exchange rate was unaltered Now suppose that, in addition, the real value of the ruble declines 25%

Example: concluded Real Asset Rb value x exchange = $ value before Rb 100,000 .04 ($/Rb) $ 4,000 after(mon.) Rb 200,000 .02 ($/Rb) $ 4,000 after(real) Rb 200,000 .015 ($/Rb) $ 3,000 Nominal Asset Rb value x exchange = $ value after(mon.) Rb 100,000 .02 ($/Rb) $ 2,000 after(real) Rb 100,000 .015 ($/Rb) $ 1,500

Summary: Exchange Rates and Asset Value

Types of Currency Exposure Transaction exposure: Occurs when contracts are denominated in a foreign currency Operating (Economic) exposure: Occurs when the value of cash flows depends on exchange rates Translation exposure: Occurs when of financial statements must be consolidated

Nature of Currency Exposures Transaction exposure: always nominal Operating (Economic) exposure: largely real Translation exposure: depends on accounting methods

Interest Rate Parity and Currency Forecasting

Interest Rate Parity Logic: Arbitrage in financial markets Return on a dollar invested must be the same everywhere Called “covered interest arbitrage”

Forward Exchange Rate An exchange rate agreed upon today for a currency exchange to be carried out at a specified date in the future.

Covered Interest Arbitrage Inequality implies a risk-free profit opportunity Borrow dollars Buy rubles Buy Russian bonds Sell rubles forward

Unbiased Forward Rate Definition - forward rates are unbiased predictors of future spot rates Logic: Speculation on forward markets Consequences Single most useful rule for currency prediction With CIA connects interest rates to expected exchange rates

CIA as an “implied” forward Borrow dollars Buy rubles Buy Russian bonds = “implicit” contract to buy rubles forward Sell rubles on (explicit) forward market

Uncovered interest arbitrage Like CIA but without using forward market Borrow dollars Buy rubles Buy Russian bonds = “implicit” contract to buy rubles forward A bet spot will exceed implied forward rate This is the “Carry trade”

Predictions based on parity conditions

Exchange rate forecasting summary Use forward rates (if available) Interest rates can be used to construct an “implied forward rate” Consider anticipated changes in real factors and monetary policies