1. Market Determinants of Exchange Rates

2. 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

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

4. Market Forces: Real Effects

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

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

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

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

9. 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

10. 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

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

12. 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

13. 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

14. 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

15. Market Forces: Monetary Effects

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

19. 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.

20. 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

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

22. Currency Exposure

23. 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

24. 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

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

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

28. 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%

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

30. Summary: Exchange Rates and Asset Value

31. 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

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

33. Interest Rate Parity and Currency Forecasting

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

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

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

38. 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

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

41. 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”

42. Predictions based on parity conditions

43. 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