Foreign Exchange Rate Determination and Forecasting

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					Foreign Exchange Rate Determination and Forecasting
Outline:

I. Balance of Payment II. Parity Conditions Purchasing Power Parity Fisher Effect International Fisher Effect Forward Rate as Unbiased Predictor of Future Spot Rate Interest Rate Parity Covered Interest Arbitrage II. Foreign Exchange Rate Forecasting in Practice Methods of Forecasting

Lecture 5

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I.

Description of Balance of Payment Accounting

Summarizes economic transaction between residents of one country and the rest of the world. Transactions include – Import and Export of goods and services – Transfers – Capital Flows etc BOP account as an itemization of the factors behind the demand and supply of a currency Rules of Debits and Credits – Credits (+): Transactions that represent demands for the local currency in the foreign exchange market. Result from purchases by foreigners of goods, services, financial and real assets, gold and foreign exchange • Export of goods and services (sale • Receipt of gifts • Borrowing (sale of stocks, bonds etc • Investment by foreign residents (real estate, expansion of plant and equipment etc • Decrease in Official Reserve of gold/foreign currency
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I.

Description of Balance of Payment Accounting cont’d

– Debits(-): Transactions that represent supplies of local currency in the foreign exchange market. Result from purchases by residents of goods, services, financial and real assets, gold, or foreign exchange from foreigners. • Import of goods and services • Gifts and Transfers • Lending (purchase of foreign stocks, bonds etc • Local investment in foreign countries • Increases in Official Reserve of gold/foreign currency Balance of Payment Categories
– – – – Current Account - flow of goods, services and transfers Capital + Financial Accounts - public and private investments and lending Errors and omissions Official Reserves Account - changes in holdings of gold and foreign currencies

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I.
A

Description of Balance of Payment Accounting cont’d
Current Account Balance (BC) Export of Goods Import of Goods Export of Services Import of Services Unilateral Transfers XX (XX) XX (XX)

XX

Trade Balance

B

C
D

XX (XX) XX Current Balance Capital (including Financial) Accounts Balance (BK) Direct Investment XX Portfolio Investment XX Short term Investments XX XX Errors and Omissions () XX XX Overall Balance Changes in Official Reserves (R) XX

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I.

Balance of payment Accounting

The Balance of Payment Accounting Identity: Assuming no errors and omissions, BC + BK + R = 0 – Flexible exchange rate system • No change in Reserve
– BC + BK = 0 => BC = - BK – correctly measured current account deficit/surplus equals correctly measured capital account surplus/deficit – current account deficit/surplus could be caused by capital account surplus/deficit

– Fixed Exchange Rate System
• BC + BK + R = 0 ==> R = - (BC + BK)

• increase/decrease in reserve equals the combined surplus or deficit. – Implications of Imbalances in BOP • Long term deficits not sustainable
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II.

Parity Conditions

Assumptions
- perfect financial markets (no taxes, no transaction costs, no informational asymmetry, many buyers and sellers) - perfect goods markets (no transaction costs, no barriers to trade, many buyers and sellers)

Purchasing Power Parity (PPP) - relates inflation rates to changes in spot rates
A. The Law of One Price
Identical products trading in different markets should cost the same. - Domestic markets (same currency) - Markets across countries - Prices expressed in common currency should be same e.g. PU.Swheat = S($/£) PUKwheat ==> S($/£) = PU.Swheat / PUKwheat

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II.
B.

Parity Conditions cont’d
PPP (absolute form)

If the law of one price holds for all goods and services for similar baskets of goods, PIU.S = S($/£) PIU.K ===> S($/£) = PIU.S / PIUK (i.e Spot exchange rate is determined by relative prices of similar baskets of goods)
C. PPP (relative form)

If the spot exchange rate between two countries starts in equilibrium, any change in differential inflation rates between them tends to be offset over a long run by an equal but opposite change in the spot exchange rate.
Exchange Rate - Direct Quote(# domestic currency/ unit of foreign currency)
S1 1  D S1  S 0  D   F      D  F 0 0 S 1  F S 1  F

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II.

Parity Conditions cont’d

Exchange Rate - Indirect Quote (# foreign currency/unit of domestic currency)
S 0 1  D S 0  S1  D   F      D  F 1 1 S 1  F S 1 IF

e.g UK inflation rate = 15%; U.S. inflation rate 10%. Hence, if the currencies were in equilibrium at the start of the period, the UK pound should fall by: (0.10 - 0.15)/ 1.15 = - 0.043 or 4.3% or approximately by, 0.10 - 0.15 = -0.05 or 5% Implications of PPP: Real return on an asset should be identical for investors of different countries . Example: Empirical Evidence:
1. Generally PPP not accurate in predicting exchange rate (particularly in the short run) 2. PPP holds well over a long run 3. PPP holds better for countries with relatively high rates of inflation.
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II.

Parity Conditions cont’d

The Fisher Effect (FE) Relates differentials in nominal interest rates to differentials in inflation rates. Fisher Closed Condition:
The nominal interest rates in each country are equal to the required real rate of return to the investor plus premium for expected inflation.

1  i  (1  r )(1   )  i  r  

Fisher Open Condition (Fisher Effect (Generalized Version)):
Differences in nominal interest rates are equal to differences in expected inflation. It asserts that real rates of returns should tend to equalize across countries; hence, nominal rates of interest will vary by the difference in expected inflation.

1  id  (1  rd )(1   d ) 1  i f  (1  rf )(1   f ) id  i f  d   f 1  id 1   d      id  i f   d   f 1 i f 1  f 1 i f 1  f
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II.

Parity Conditions cont’d

International Fisher Effect (IFE) The spot exchange rate should change in an equal but opposite direction to the difference in nominal interest rates between two countries.
s1 1   d Re call, PPP  0  s 1  f Fisher  Open  1   d 1  id  1  f 1 i f

s1 1  id s1  s 0 id  i f s1  s 0 International  Fisher  0      id  i f s 1 if s0 1 if s0

Forward Rate as an Unbiased Predictor of the Future Spot Rate
F E[ s1 ] F  s 0 E[ s1  s 0 ] F  E[ s ]  0  0   s s s0 s0
1

i.e. Forward premium on foreign currency equals forecasted change in the spot rate.
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II.

Parity Conditions cont’d

Interest Rate Parity (IRP)
Except for transaction costs, a difference in national interest rate for securities of similar risk and maturity should be equal but opposite sign to the forward exchange rate discount or premium for the foreign currency. Suppose that a U.S. investor is considering to invest $1 in a money market instrument for a year. Alternative 1: Invest in U.S. ($ denominated) money market instrument Return = $1 (1 + i ($)) Alternative 2: Invest in foreign money market instrument (say in Japanese Yen) Buy Yen at spot ==> # of yen = 1/S (Assume direct quote ($/Yen) Sell Yen forward (buy dollar forward) at F Return in Yen = 1/S (1 + i (¥)) Convert Yen into $ using forward rate F Return = 1/S (1 + i (¥)) F IRP ==> $1 (1 + i ($)) = 1/S (1 + i (¥)) F ==> F/S = (1 + i ($)) / (1 + i (¥))
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II.

Parity Conditions cont’d

In general (assuming direct quote (# domestic currency/ unit of foreign currency),
id  i f 1  id F F  S0    S0 1 i f S0 1 i f F  S0 F  S0   id  i f  id  i f  S0 S0

Covered Interest Arbitrage (CIA)
If IRP does not hold, an arbitrageur can earn “riskless” profit by investing in the currency that offers higher return on covered basis. Illustration:

Two money market instruments: Dollar money market - i($) = 8% per annum Yen money market - i(¥) = 5% per annum Exchange rates: Spot (S0) = ¥ 135/$ Forward rate (180 days) = ¥ 134.5 /$ Assume that the arbitrageur can borrow or lend $1,000,000 equivalent in the two markets.
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II.

Parity Conditions cont’d

Step 1: check if IRP holds:

S/F = (1+ id)/(1+ if) = =>

¥135/ ¥ 134.5  1.04/1.025

 there exists an arbitrage opportunity
Step 2: Identify where to invest and where to borrow Method 1: determine implied (i.e. IRP consistent) interest rate of one of the currencies S/F = ¥ 135/ ¥ 134.5 = 1.0037 = (1 + id )/ 1.025 (by IRP) ==> (1 + id ) = 1.0288103 or id = 0.0288/ 6 months Vs 0.04 (actual rate)

 cheaper to borrow in Yen market and invest in Dollar market (i.e. Id)
Method 2: compare the domestic rate against the effective foreign rate using IRP Recall, from IRP

F  s0 s0  F id  i f  or ( ) 0 s F

id = 4%

Vs

if + (s0 - F / F) = 0.025 + (135- 134.5) / 134.5 = 0.0287

 cheaper to borrow in Yen market and invest in Dollar market (i.e. Id)
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II.

Parity Conditions cont’d
Step 3: outline the arbitrage strategy 1. Borrow $1 m equivalent in ¥ ($1,000,000 @ ¥ 135 = ¥ 135,000,000)
2. Convert to $ at spot rate of ¥ 135 / $ = $1,000,000 Buy forward contract to buy ¥ @ forward rate of ¥ 134.5/$ 3. Invest in $ money market instrument for 6 months Total Return: $1,000,000 (1.04) = $1,040,000 4. Repay loan Loan in ¥ = ¥ 135,000,000 (1.025) = ¥ 138,375,000 Loan in $ ( @ F) = ¥ 138,375,000/ ¥ 134.5 = $ 1,028,810.40 Profit in $(excluding transaction costs) = $1,040,000 - $1,028,810.40=$11,189.60

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III.

Foreign Exchange Rate Forecasting

Approaches to Forecasting 1. Technical Analysis - Based on trends of data series
- used mostly for short term forecasting

2.

Fundamental Analysis - based on financial and economic theory
• The Balance of Payments Approach
– – – Analysis of a country’s BOP as indicator of pressure on exchange rate An exchange rate between two currencies represents the price that balances the relative supplies and demands of assets denominated in those currencies . Hence, the relative attractiveness of a currency for investment purposes is a deriving force of exchange rate movements.

• The Asset Market Approach

Example:

impact of high economic growth

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III. Foreign Exchange Rate Forecasting in Practice cont’d
Short run forecasts: - for periods less than a year - motivated by a desire to hedge receivables, payables etc - accuracy more important - techniques include: time series techniques fitting trends Forward rate as predictor of future spot rate Long run forecasting - motivated by MNC’s desire to initiate direct foreign investment, raise long term finance etc. - forecast accuracy not critical - recommended techniques include: fundamental analysis, including analysis of balance of payments, relative inflation rates and interest rates.

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