ECW2721 Lecture W8 Forex

WEEK 8
Chapter 9
The
Determinants of
Exchange Rates
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Belarus National Bank has announced 56% devaluation of its national currency the
Belarusian rouble, thus evoking panic amongst Belarus residents, hurriedly stocking up
food and other goods.
Learning Objectives
To understand the various approaches to forecasting the exchange
rates
To understand the strengths and limitations of each approach
To understand exchange rate movements over the short and long
term.
Reading:
Australian edition (Chapter 9)
Global edition (Chapter 9)

Week 8
4
Foreign Exchange Rate
Determination
Exchange rate determination is complex.
Exhibit 9.1 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.
Foreign Exchange Rate
Determination
Without the depth and breadth of the various
approaches combined, our ability to capture the
complexity of the global market for currencies is
lost.
In addition to gaining an understanding of the basic
theories, it is equally important to gain a working
knowledge of:
the complexities of international political economy;
societal and economic infrastructures; and,
random political, economic, or social events that affect the
exchange rate markets.

Exhibit 9.1 The Determinants of
Foreign Exchange Rates
Exchange Rate Determination:
The Theoretical Thread
The previous exhibit, with its tripartite
categorization of exchange rate theory is a
good start but in our humble opinion is
not robust enough to capture the multitude
of theories and approaches.

Therefore, in the following slides, we will
introduce several additional streams of
thought.
The theory of purchasing power parity is the
most widely accepted theory of all exchange
rate determination theories:
The long-run equilibrium exchange rate is
determined by the ratio of domestic prices (Pd)
relative to foreign prices (Pf).
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.
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--vis current and financial account activities.
CA = -FA or CA = FA
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.
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.

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.
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.
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 countrys economic and social infrastructure
Political safety
Corporate governance practices
Contagion (spread of a crisis within a region)
Speculation
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).
Currency Market Intervention
(Why?)
Foreign currency intervention is the active
management, manipulation, or intervention
in the markets valuation of a countrys
currency.
Why Intervene?
Fight inflation (strong currency)
Fight slow economic growth (weak currency)
(How?)
Methods of intervention are determined by
magnitude of a countrys economy,
magnitude of trading in its currency, and
the countrys 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

(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 is 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

(How?)
Capital Controls are restrictions of access to foreign
currency by the government by limiting the exchange of
domestic currency for foreign currency.

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.
Illustrative Case: The Asian Crisis
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.
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 9.2) and
soon other Asian currencies (Philippine peso,
Malaysian ringgit and the Indonesian rupiah)
came under speculative attack.
Exhibit 9.2 The Thai Baht and the
Asian Crisis
Sirivat Sandwich

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.
June 1967: The old Sterling-
linked Malayan/Straits Dollar
was replaced by separate
dollars of Malaysia (RM),
Singapore and Brunei.
February 1973: Following the
U.S. Dollar devaluation, the
RM was realigned to
M$2.5376 per U.S. dollar,
based on the currency's
unchanged gold content.

June 1973: Malaysia placed
the Effective rate for her
dollar on a controlled, floating
basis. Bank Negara Malaysia
intervened in order to
maintain relative stability in
the value of Ringgit in relation
to the basket of currencies.
2 September 1998: The exchange rate was no
longer determined by demand and supply. The
Central Bank announced that the exchange rate of
the Ringgit would be pegged against the U.S.
Dollar at RM3.80 = $1.

In July 2005, the Ringgit no longer pegged to the
US dollar, but shifted to a managed float system.

Malaysia Exchange Rates
(RM/$US)
Illustrative Case:
The Russian Crisis of 1998
Debt service had become a real problem
Capital flight was taking place
The ruble traded via a managed float that had
been continually adjusted since 1996
August 7, 1998 began the August Crash with the
announcement that currency reserves had fallen
$800M in the last week
August 10, the Russian stock market falls 5%
August 17, Russia announces the ruble will be
allowed to devalue by 34%
Exhibit 9.3 illustrates the rubles decline
Exhibit 9.3 The Fall of the Russian
Ruble
Technical Analysis

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.
really just studies supply and demand in a market
attempts to understand the emotions in the market by studying the
market itself.
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

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 9.5 summarizes the various forecasting
periods, regimes, and the authors suggested
methodologies.

Exhibit 9.5 Exchange Rate
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
currencys value.
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 9.6 illustrates the synthesis of forecasting
thought.
Exhibit 9.7 shows the dynamics of exchange rate
manipulation.

Exhibit 9.6 Short-Term Noise
Versus Long-Term Trends
Exhibit 9.7 Exchange Rate
Dynamics: Overshooting

What Determines the Exchange Rate: Economic
Factors or Market Sentiment?
Gregory P. Hopper
http://wps.aw.com/wps/media/objects/744/761963/rdg39.p
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