1. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall1 Chapter 10: Exchange Rate Determination and Forecasting Power Points created by: Joseph F. Greco Ph. D. California State University, Fullerton Mihaylo College of Business and Economics

2. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall2 Chapter 10: Exchange Rate Determination and Forecasting 10.1Parity Conditions and Exchange Rate Forecasts 10.2Currency Forecasting Techniques 10.3Fundamental Exchange Rate Forecasting 10.4Technical Analysis 10.5 Predicting Devaluations

3. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall3 10.1Parity Conditions and Exchange Rate Forecasts Parity Conditions and Exchange Rate Forecasts: Overview The Fisher Hypothesis The International Parity Conditions Real Interest Rates and the Parity Conditions

4. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall4 10.1Parity Conditions and Exchange Rate Forecasts The Fisher Hypothesis Interest rates and inflation Real rates of return The Ex Ante real interest rate Expected real interest rate Expected rate of inflation Fisher hypothesis

5. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall5 Exhibit 10.1 Long-Term Government Bond Yields and Inflation Rates (for Nine Countries, 1990-2000)

6. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall6 10.1Parity Conditions and Exchange Rate Forecasts The International Parity Conditions CIRP UIRP or Unbiasedness PPP

7. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall7 Exhibit 10.2 An Example of International Parity Conditions: The United Kingdom and Switzerland

8. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall8 10.1Parity Conditions and Exchange Rate Forecasts Real Interest Rates and the Parity Conditions Real interest rate parity Testing real interest rate parity Assessment

9. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall9 Exhibit 10.3 Real Interest Rates at Different Maturities

10. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall10 10.2 Currency Forecasting Techniques Currency Forecasting Techniques: Overview Fundamental Exchange Rate Forecasting Exchange Rate Forecasting with Technical Analysis Evaluating Forecasts

11. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall11 10.2 Currency Forecasting Techniques Fundamental Exchange Rate Forecasting Fundamental analysis Technique based on formal economic models of exchange rate determination

12. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall12 Exhibit 10.4 Categories of Exchange Rate Forecasting Techniques

13. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall13 10.2 Currency Forecasting Techniques Exchange Rate Forecasting with Technical Analysis Technical analysis Why technical analysis might work

14. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall14 10.2 Currency Forecasting Techniques Evaluating Forecasts Accuracy Mean absolute error (MAE) Root mean squared error (RMSE) Being on the right side of the forward rate Percentage correct Profitability

15. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall15 10.3 Fundamental Exchange Rate Forecasting Fundamental Exchange Rate Forecasting: Overview The Asset market Approach to Exchange Rate Determination Sticky Prices and Overshooting The Real Exchange Rate and the Real Interest Rate Differential The Real Exchange Rate and the Current Account The Capital Account and Real Exchange Rates Equilibrium Variables That Affect the Real Exchange Rate-Current Account Equilibrium Forecasting Performance of Fundamental Exchange Rate Models

16. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall16 10.3 Fundamental Exchange Rate Forecasting The Asset market Approach to Exchange Rate Determination The exchange rate as an asset price The monetary approach Real money balances Sticky Prices and Overshooting Responses to an increase in the money supply The link with UIRP The path of prices

17. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall17 Exhibit 10.5 Responses of Variables to an Increase in the Money Supply

18. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall18 10.3 Fundamental Exchange Rate Forecasting The Real Exchange Rate and the Real Interest Rate Differential Converting UIRP to real terms Implications of an autoregressive process for the real exchange rate Autoregressive process Empirical evidence

19. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall19 Exhibit 10.6 Movements in the Real Dollar Exchange Rate Relative to the Real Interest Rate Differential

20. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall20 10.3 Fundamental Exchange Rate Forecasting The Real Exchange Rate and the Current Account The trade balance and real exchange rates The Capital Account and Real Exchange Rates Equilibrium Variables That Affect the Real Exchange Rate- Current Account Equilibrium Net foreign assets Government spending and budget deficits Technological change and productivity growth Portfolio shifters

21. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall21 Exhibit 10.7 Equilibrium Determination of the Current Account and the Exchange Rate

22. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall22 10.3 Fundamental Exchange Rate Forecasting Forecasting Performance of Fundamental Exchange Rate Models Forecasting models and benchmarks Empirical results

23. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall23 10.4 Technical Analysis Technical Analysis: Overview “Pure” Technical Analysis: Chartism Filter Rules Regression Analysis Evaluating Forecasting Services

24. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall24 10.4 Technical Analysis “Pure” Technical Analysis: Chartism Support level Resistance level Breakout Potentially Spurious Patterns Trading on a Random Walk Does charting work?

25. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall25 Exhibit 10.8 Exchange Rate Patterns Described by Chartists

26. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall26 Exhibit 10.8 Exchange Rate Patterns Described by Chartists

27. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall27 10.4 Technical Analysis Filter Rules x% rules Moving-average crossover rules Filter rule profitability Assessment

28. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall28 10.4 Technical Analysis Regression Analysis Trading based on regressions Regression-based currency strategies in practice Evaluating Forecasting Services

29. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall29 Exhibit 10.9 How Filter Rules Work

30. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall30 10.5 Predicting Devaluations Predicting Devaluations: Overview What Causes a Currency Crisis? Empirical Evidence on the Predictability of Currency Crisis

31. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall31 10.5 Predicting Devaluations What Causes a Currency Crisis? Macroeconomic Conditions Self-fulfilling expectations Contagion

32. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall32 10.5 Predicting Devaluations Empirical Evidence on the Predictability of Currency Crisis 1991-1992: Currency turmoil in Europe 1994-1995: Mexican crisis and the Tequila effect 1997: The Southeast Asian crisis

33. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall33 Exhibit 10.10 - Asian Exchange Rates