1. Foreign Exchange Rate Determination
Lecture 3
Foreign Exchange Rate
Determination

2. Some basic questions Why aren’t FX rates all equal to one?
Why do FX rates change over time?
Why don’t all FX rates change in the same direction?
What drives forward rates – the rates at which you can trade currencies at some future date?
FIN 509 Spring 2004

3. Exchange Rate Determination
Exchange rate determination is complex.
Exhibit 3.1 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 of payments approach, asset market approach), and secondly by the individual drivers within those approaches.
These are not competing theories but rather complementary theories.

4. Exhibit 3.1 The Determinants of Foreign Exchange Rates

5. Exchange Rate Determination
Two other institutional dimensions are considered—whether the country possesses the capital markets and banking systems needed to drive and discover value.
Most determinants of the spot exchange rate are mutually determined by changes in the spot rate.

6. Exchange Rate Determination: The Theoretical Thread
The theory of purchasing power parity is the most widely accepted theory of all exchange rate determination theories:
PPP is the oldest and most widely followed of the exchange rate theories.
Most exchange rate determination theories have PPP elements embedded within their frameworks.
PPP calculations and forecasts are however plagued with structural differences across countries and significant data challenges in estimation.

7. The Purchasing Power Parity Theory (PPP)
The PPP theory was developed by Swedish economists Gustav Cassel in 1920 to determine the exchange rate between countries on inconvertible paper currencies.
This theory states that, the rate of exchange between two countries is determined by purchasing power in two different countries.
PPP have two versions:
The absolute purchasing power parity theory
The relative purchasing power parity theory

8. Purchasing power parity
Law of One Price
Versions of
PURCHASING
POWER
PARITY
Absolute PPP
Relative PPP
FIN 509 Spring 2004

9. The Law of One Price
A commodity will have the same price in terms of common currency in every country
In the absence of frictions (e.g. shipping costs, tariffs,..)
Example
Price of wheat in France (per bushel): P€
Price of wheat in U.S. (per bushel): P$
S€/$ = spot exchange rate
P€ = s€/$  P$
FIN 509 Spring 2004

10. The Law of One Price Example:
Price of wheat in France per bushel (p€) = 3.45 €
Price of wheat in U.S. per bushel (p$) = $4.15
S€/$ = (s$/€ = )
Dollar equivalent price
of wheat in France = s$/€ x p€
= $/€ x 3.45 € = $4.15
 When law of one price does not hold, supply and demand forces help restore the equality
FIN 509 Spring 2004

11. Absolute PPP Extension of law of one price to a basket of goods
Absolute PPP examines price levels
Apply the law of one price to a basket of goods with price P€ and PUS (use upper-case P for the price of the basket):
where P€ = i (wFR,i  p€,i )
PUS = i (wUS,i  pUS,i )
S€/$ = P€ / PUS
FIN 509 Spring 2004

12. Absolute PPP
If the price of the basket in the U.S. rises relative to the price in Euros, the U.S. dollar depreciates:
May 21 : s€/$ = P€ / PUS
= € / $ = €/$
May 24: s€/$ = € / $ = €/$
FIN 509 Spring 2004

13. Relative PPP Absolute PPP: Relative PPP: P€ = s€/$  P$
For PPP to hold in one year:
P€ (1 + i€) = E(s€/$)  P$ (1 + i$),
or: P€ (1 + i€) = s€/$ [E(s€/$)/s€/$ )]  P$ (1 + i$)
Using absolute PPP to cancel terms and rearranging:
Relative PPP:
P€ = s€/$  P$
1 + i€ = E(s€/$)
1 + i$ s€/$
FIN 509 Spring 2004

14. Relative PPP
Main idea – The difference between (expected) inflation rates equals the (expected) rate of change in exchange rates:
1 + i€ = E(s€/$)
1 + i$ s€/$
FIN 509 Spring 2004

15. Relative PPP
According to this version, the change in the exchange rate over a specific period of time should be proportional to the relative change in price level in the two nations over the same period of time
The formula used for determination of exchange rate is:
R1 =P1a/P0 . R0
where R1 shows exchange rate in period 1, and R0 shows exchange rate in base period
For example if general price level does not change in foreign nation from the base period to period 1, Where as general price level in the home nation increase by 50%
P1b/P0

16. Relative PPP
So according to PPP theory the exchange rate (price of a unit of foreign currency in term of domestic currency) should be 50% higher in period 1 as compared to the base period (home currency depreciated by 50%)
This theory can be explain with the help of other example:
Suppose India and England are on inconvertible paper standard and by spending Rs.60, the bundle of goods can be purchased in India as can be bought by spending £ 1 in England. Thus, according to PPP, the rate of exchange will be Rs. 60= £ 1.
Suppose domestic price index increase by 300 and foreign price index rises to 200 the new exchange rate will be Rs 60 =£1.5
The exchange rate would be a proper reflection of the purchasing power in each country if the relative values bought the same amount of goods in each country.

17. Statistical difficulties
Deviations from PPP
Simplistic model
Why does
PPP
not
hold?
Imperfect Markets
Statistical difficulties
FIN 509 Spring 2004

18. Statistical difficulties
Deviations from PPP
Transportation costs
Tariffs and taxes
Consumption patterns differ
Non-traded goods & services
Sticky prices
Markets don’t work well
Construction of price indexes
- Different goods
- Goods of different qualities
Simplistic model
Imperfect Markets
Statistical difficulties
FIN 509 Spring 2004

19. What is the evidence? The Law of One Price frequently does not hold.
Absolute PPP does not hold, at least in the short run.
See The Economist’s Big Mac Currencies
Homework: Use The Economist Big Mac Index: July 2018 and January 2019
Use January 2019 index and identify whether Euro, Japanese Yen, Great British Pound, Chinese Yuan, Swiss Frank and your own country’s currencies are overvalued or undervalued against US$.
Compare today's exchange rates with July rates and discuss whether the big mac index gives right directions or not.
The data largely are consistent with Relative PPP, at least over longer periods.
FIN 509 Spring 2004

20. Interest rate parity
Main idea: There is no fundamental advantage to borrowing or lending in one currency over another
This establishes a relation between interest rates, spot exchange rates, and forward exchange rates
Forward market: Transaction occurs at some point in future
BUY: Agree to purchase the underlying currency at a predetermined exchange rate at a specific time in the future
SELL: Agree to deliver the underlying currency at a predetermined exchange rate at a specific time in the future
FIN 509 Spring 2004

21. INTEREST RATE PARITY THEORY
The Theory states that:
the forward rate (F) differs from the spot rate (S) at equilibrium by an amount equal to the interest differential (rh - rf) between two countries.
The forward premium or discount equals the interest rate differential.
(F - S)/S = (rh - rf)
where rh = the home rate
rf = the foreign rate

22. INTEREST RATE PARITY THEORY
In equilibrium, returns on currencies will be the same
i. e. No profit will be realized
and interest parity exists
which can be written as:
(1 + rh) = F
(1 + rf) S

23. INTEREST RATE PARITY THEORY
Covered Interest Arbitrage
If interest rate differential does not equal the forward premium or discount.
Funds will move to a country with a more attractive rate.
Market pressures develop:
As one currency is more demanded spot and sold forward
Inflow of fund depresses interest rates.
Parity eventually reached.

24. INTEREST RATE PARITY THEORY
In summary:
Interest Rate Parity states:
Higher interest rates on a currency offset by forward discounts.
Lower interest rates are offset by forward premiums.

25. Example of a forward market transaction
Suppose you will need 100,000€ in one year
Through a forward contract, you can commit to lock in the exchange rate
f$/€ : forward rate of exchange
Currently, f$/€ =  1 € buys $
 1 $ buys €
At this forward rate, you need to provide $119,854 in 12 months.
FIN 509 Spring 2004

26. Interest Rate Parity START (today) END (in one year) r$=2.24% $117,228
$117,228  = $119,854
(Invest in $)
One year
s€/$=
f€/$=
(Invest in €)
$117,228  = 97,551€
97,551€  = 100,000€
r€=2.51%
FIN 509 Spring 2004

27. Interest rate parity
Main idea: Either strategy gets you the 100,000€ when you need it.
This implies that the difference in interest rates must reflect the difference between forward and spot exchange rates
Interest
Rate Parity:
1 + r€ = f€/$
1 + r$ s€/$
FIN 509 Spring 2004

28. Interest rate parity example
Suppose the following were true:
Does interest rate parity hold?
Which way will funds flow?
How will this affect exchange rates?
U.S Dollar
Euro
12 month interest rate
2.24%
2.70%
Spot rate
€ / $
Forward rate
€ / $
FIN 509 Spring 2004

29. Evidence on interest rate parity
Generally, it holds
Why would interest rate parity hold better than PPP?
Lower transactions costs in moving currencies than real goods
Financial markets are more efficient that real goods markets
FIN 509 Spring 2004

30. Exchange Rate Determination: The Theoretical Thread
The balance of payments approach is the second most utilized theoretical approach in exchange rate determination:
The basic approach argues that the equilibrium exchange rate is found when currency flows match up vis-à-vis current and financial account activities.
This framework has wide appeal as BOP transaction data is readily available and widely reported.
Critics may argue that this theory does not take into account stocks of money or financial assets.

31. The Balance of Payment Approach
According to this theory ,exchange rate of a currency depends on its BOP position
A favorable BOP raise the exchange rate
And unfavorable BOP reduces the exchange rate
Thus according to this theory exchange rate is determined by the demand and supply of foreign exchange
Demand for foreign exchange arises from the debit side of the balance sheet
Supply of foreign exchange arises from credit side of balance sheet

32. The Balance of Payment Approach
When BOP is unfavorable it means that demand for foreign currency is more than its supply
It means that external value of domestic currency in relation to foreign currency fall
Consequently exchange rate to fall…..how ?
Suppose RS 60=$1 , external value of domestic currency is .017
Due to unfavorable BOP Rs90=$1 so external value of domestic currency is ……… .011
On other hand if BOP is favorable it means that supply of foreign is greater than demand
It means that external value of domestic currency in relation to foreign currency rise

33. The Balance of Payment Approach
Consequently exchange rate to rise
Suppose RS 60=$1, so external value of domestic currency is .017
Due to favorable BOP Rs 40=$1 so external value of domestic currency is ……… .025
In conclusion, in foreign exchange determination BOP is important

34. BOP Approach: Determination of exchange rate
price of $ in Rupee S R2 R
Exchange rate R1 S D Q
Dollars

35. Exchange Rate Determination: The Theoretical Thread
The monetary approach in its simplest form states that the exchange rate is determined by the supply and demand for national monetary stocks, as well as the expected future levels and rates of growth of monetary stocks.
Other financial assets, such as bonds are not considered relevant for exchange rate determination, as both domestic and foreign bonds are viewed as perfect substitutes.

36. Exchange Rate Determination: The Theoretical Thread
The asset market approach argues that exchange rates are determined by the supply and demand for a wide variety of financial assets:
Shifts in the supply and demand for financial assets alter exchange rates.
Changes in monetary and fiscal policy alter expected returns and perceived relative risks of financial assets, which in turn alter exchange rates.

37. Exchange Rate Determination: The Theoretical Thread
The forecasting inadequacies of fundamental theories has led to the growth and popularity of technical analysis, the belief that the study of past price behavior provides insights into future price movements.
The primary assumption is that any market driven price (i.e., exchange rates) follows trends.

38. The Asset Market Approach to Forecasting
The asset market approach assumes that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations or drivers (among others):
Relative real interest rates
Prospects for economic growth
Capital market liquidity
A country’s economic and social infrastructure
Political safety
Corporate governance practices
Contagion (spread of a crisis within a region)
Speculation

39. The Asset Market Approach to Forecasting
Foreign investors are willing to hold securities and undertake foreign direct investment in highly developed countries based primarily on relative real interest rates and the outlook for economic growth and profitability.
The asset market approach is also applicable to emerging markets; however in these cases, a number of additional variables contribute to exchange rate determination (previous slide).

40. Currency Market Intervention (Why?)
Foreign currency intervention is the active management, manipulation, or intervention in the market’s valuation of a country’s currency.
Why Intervene?
Fight inflation (strong currency)
Fight slow economic growth (weak currency)

41. Currency Market Intervention (How?)
Methods of intervention are determined by magnitude of a country’s economy, magnitude of trading in it’s currency, and the country’s 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 the central bank buys its own currency
If the goal is to decrease the value, then the central bank sells its own currency

42. Currency Market Intervention (How?)
If bank intervention is insufficient, then coordinated intervention may be used whereby several central banks agree on a strategy to increase or decrease a currency value.
Indirect Intervention
the alteration of economic or financial fundamentals which are thought to be drivers of capital to flow in and out of specific currencies
Increase real rates to strengthen a currency
Decrease real rates to weaken a currency

43. Currency Market Intervention (How?)
Capital controls are restrictions of access to foreign currency by the government by limiting the exchange of domestic currency for foreign currency.
Although intervention may fail, understanding the motivations and methods for currency market intervention is critical to any analysis of the determination of future exchange rates.

44. Exhibit 9.2 Intervention and the Japanese Yen, 2010

45. Exhibit 9.3 The History of Japanese Intervention

46. Disequilibrium: Exchange Rates in Emerging Markets
Although the three different schools of thought on exchange rate determination (parity conditions, balance of payments approach, asset approach) make understanding exchange rates appear to be straightforward, that it rarely the case.
The large and liquid capital and currency markets follow many of 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 the assumptions underlying the theory.

47. The Asian Crisis of 1997
The roots of the Asian currency crisis extended from a fundamental change in the economics of the region, the transition of many Asian nations from being net exporters to net importers.
The most visible roots of the crisis were the excess capital inflows into Thailand in 1996 and early 1997.
As the investment “bubble” expanded, some market participants questioned the ability of the economy to repay the rising amount of debt and the Thai bhat came under attack.

48. The Asian Crisis of 1997
The Thai government intervened directly (using up precious hard currency reserves) and indirectly by raising interest rates in support of the currency.
Soon thereafter, the Thai investment markets ground to a halt and the Thai central bank allowed the bhat to float.
The bhat fell dramatically (see Exhibit 9.4) and soon other Asian currencies (Philippine peso, Malaysian ringgit and the Indonesian rupiah) came under speculative attack.

49. Exhibit 9.4 The Thai Baht and the Asian Crisis

50. The Asian Crisis of 1997
The Asian economic crisis (which was much more than just a currency collapse) had many roots besides traditional balance of payments difficulties:
Corporate socialism
Corporate governance
Banking liquidity and management
What started as a currency crisis became a region-wide recession.

51. The Argentine Crisis of 2002
In 1991 the Argentine peso had been fixed to the U.S. dollar at a one-to-one rate of exchange.
A currency board structure was implemented in an effort to eliminate the source inflation that had devastated the nation’s standard of living in the past.

52. The Argentine Crisis of 2002
By 2001, after three years of recession, three important problems with the Argentine economy became apparent:
The Argentine peso was overvalued
The currency board regime had eliminated monetary policy alternatives for macroeconomic policy
The Argentine government budget deficit – and deficit spending – was out of control

53. The Argentine Crisis of 2002
In January 2002, the peso was devalued as a result of enormous social pressures resulting from deteriorating economic conditions and substantial runs on banks.
However, the economic pain continued and the banking system remained insolvent.
Social unrest continued as the economic and political systems within the country collapsed; certain government actions set the stage for a constitutional crisis.
Exhibit 9.5 tracks the decline of the Argentine peso.

54. Exhibit 9.5 The Collapse of the Argentine Peso

55. Forecasting in Practice
Technical analysts, traditionally referred to as chartists, focus on price and volume data to determine past trends that are expected to continue into the future.
The single most important element of technical analysis is that future exchange rates are based on the current exchange rate.
Exchange rate movements can be subdivided into three periods:
Day-to-day
Short-term (several days to several months)
Long-term

56. Forecasting in Practice
The longer the time horizon of the forecast, the more inaccurate the forecast is likely to be.
Whereas forecasting for the long run must depend on the economic fundamentals of exchange rate determination, many of the forecast needs of the firm are short to medium term in their time horizon and can be addressed with less theoretical approaches.
Exhibit 9.6 summarizes the various forecasting periods, regimes, and the authors’ suggested methodologies.

57. Exhibit 9.6 Exchange Rate Forecasting in Practice

58. Forecasting: What to Think?
It appears, from decades of theoretical and empirical studies, that exchange rates do adhere to the fundamental principles and theories previously outlined.
Fundamentals do apply in the long term
There is, therefore, something of a fundamental equilibrium path for a currency’s value.

59. Forecasting: What to Think?
It also seems that in the short term, a variety of random events, institutional frictions, and technical factors may cause currency values to deviate significantly from their long-term fundamental path.
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 with some regularity and relative longevity.
Exhibit 9.7 illustrates the synthesis of forecasting thought.
Exhibit 9.8 shows the dynamics of exchange rate manipulation.

60. Exhibit 9.7 Short-Term Noise Versus Long-Term Trends

61. Exhibit 9.8 Exchange Rate Dynamics: Overshooting

62. Global Finance in Practice 9
Global Finance in Practice 9.1 Technical Analysis of the JPY/USD Rate (January 2011– February 2014)

63. Global Finance in Practice 9
Global Finance in Practice 9.3 The European Monetary System’s “Snake in a Tunnel”

64. Global Finance in Practice 9
Global Finance in Practice 9.5 JPMorgan Chase Forecast of the Dollar/Euro