Chapter 10

Foreign Exchange
Rate Determination
and Forecasting
The Goals of Chapter 10
Summarized the theories to determine the exchange
rate, including the purchasing power parity approach,
the balance of payments approach, the monetary
approach, the asset market approach, and the
technical analysis
Introduce the crises in emerging markets, including the
Asian crisis in 1997 and the Argentine crisis in 2002
Discuss the forecasting of the exchange rate in
practice

10-2
Foreign Exchange Rate
Determination
10-3
Foreign Exchange Rate
Determination
Exchange rate determination is complex
The three major schools of thought are the balance of
payments approach (Ch 4), international parity
conditions (Ch 7), and the asset market approach
The exhibit on the next slide provides an overview of the
many determinants of exchange rates
In addition to focusing on the asset market approach,
the monetary approach and the technical analysis are
also introduced in this chapter
These are not competing but rather complementary
theories, so understanding all of them can enhance
our ability to capture the complexity of global
currency markets and exchange rates
10-4
Exhibit 10.1 The Determinants of
Foreign Exchange Rates
I nternational Parity Conditions (Ch 7)
1. Relative inflation rates (RPPP)
2. Relative interest rates (international Fisher effect)
3. Forward exchange rates
4. Interest rate parity (IRP)
Balance of Payments (Ch 4)
1. Current account balances
2. Portfolio investment
3. Foreign direct investment
4. Official monetary reserves
5. Exchange rate regimes
Asset Market Approach (Ch 10)
1. Relative real interest rates
2. Prospects for economic growth
3. Supply & demand for financial assets
4. Outlook for political stability
5. Speculation & market liquidity
6. Contagion & corporate governance
Spot
Exchange
Rate

Monetary Approach

Technical Analysis

Most determinants of the exchange rate, e.g., the balance of BOP, the inflation
rates, the nominal and real interest rates, and the economic prospects, are also in
turn affected by changes in the exchange rate
In other words, they are not only linked but mutually determined
10-5
Foreign Exchange Rate
Determination
In addition to gaining an understanding of the basic
theories or determining factors for the exchange rate, it
is equally important to gain the following knowledge
which could affect the exchange rate markets
1. The complexities of international political economy
Foreign political risks have been much reduced in recent years
because more countries adopted democratic form of
government, so capital markets became less segmented from
each other and more liquid
2. Societal and economic infrastructures
Infrastructure weakness were the major reasons of the exchange
rate collapses in emerging markets in the late 1990s
3. Random political, economic, or social events
For example, recent occurrences of terrorism may increase the
political risks and affect the exchange rate market


10-6
Exchange Rate Determination:
The Theoretical Thread
10-7
Exchange Rate Determination:
The Theoretical Thread
This section will provide a brief overview of the many
different theories to determine exchange rate and their
relative usefulness in forecasting
The theories discussed in this section include
Purchasing power parity approach
Balance of payments (flows) approach
Monetary approach
Asset market approach
Technical analysis
10-8
Exchange Rate Determination:
The Theoretical Thread
The theory of Purchasing Power Parity states that
the exchange rate is determined as the relative prices
of goods
PPP is the oldest and most widely followed exchange rate
theory
Paul Krugman, Nobel Prize laureate in Economics in 2008,
said that Under the skin an international economist lies a
deep-seated belief in some variant of the PPP theory of the
exchange rate
Most exchange rate determination theories have PPP
elements embedded within their frameworks
However, PPP calculations and forecasts are plagued with
structural differences across countries (e.g., different tax
rules or many non-tradable production factors) and
significant challenges of data collecting in estimation
10-9
Exchange Rate Determination:
The Theoretical Thread
The Balance of Payments (Flows) approach argues that
the equilibrium exchange rate is determined through the
demand and supply of currency flows from current and
financial account activities
The BOP method is the second most utilized theoretical
approach in exchange rate determination
Today, this method is largely dismissed by academics , but practitioners
still rely on different variations of the theory for decision making
This framework is appealing since the BOP transaction data is
readily available and widely reported
Critics may argue that this theory emphasizes on flows of
currency, but stocks of currency or financial assets of
residents play no role in exchange rate determination
The monetary approach considers the currency stocks of residents
The asset market approach argues that exchange rates are altered by
shifts in the supply and demand of financial assets 10-10
Exchange Rate Determination:
The Theoretical Thread
The Monetary Approach states that the supply and
demand for currency stocks, as well as the expected
growth rates of currency stocks, will determine the
price level or the inflation rate and thus explain changes
of the exchange rate according to PPP
The arguments are all about currency stocks of residents
The inference is to link the demand or the supply of currencies
with residents behavior to adjust the stock of currencies
Main results of the monetary approach are as follows:
Currency supply domestic currency depreciation
1. Currency supply supply of currency > demand of
currency residents current currency holding > residents
desired currency holding residents spend the currency
price level according to PPP, domestic currency depreciates
2. Domestic currency supply growth rate > foreign currency supply
growth rate domestic currency depreciates vs. foreign currency 10-11
Exchange Rate Determination:
The Theoretical Thread
Interest rate domestic currency depreciation
1. Interest rate opportunity cost for residents to hold the
currency increases demand of currency residents
current currency holding > residents desired currency
holding residents spend the currency price level
according to PPP, domestic currency depreciates
2. Increase of domestic interest rate > increase of foreign interest
rate domestic currency depreciates against foreign currency
Real income domestic currency appreciation
1. Real income (= real GDP = outputs of products and services )
number of transactions demand of currency
residents current currency holding < residents desired
currency holding residents decrease the spending of the
currency price level (or because the supply of products and
services , price level and less currency is spent to achieve the
same utility) according to PPP, domestic currency appreciates
2. Domestic real income growth rate > foreign real income growth
rate (domestic economic growth > foreign economic growth)
domestic currency appreciates against foreign currency
10-12
Exchange Rate Determination:
The Theoretical Thread
The monetary approach omits a number of factors:
The failure of PPP to hold in the short to medium term
The change of the interest rate and the real income will
affect the economic activities and thus affect the currency
supply
In the above inference, however, the change of the interest
rate and the real income affect only the currency demand
Currency demand appearing to be relatively unstable over
time
There are many factors other than the interest rate and the real
income to affect the money demand, e.g., the economic boom
or recession, so the money demand is difficult to be predicted
10-13
Exchange Rate Determination:
The Theoretical Thread
The Asset Market Approach argues that the
exchange rate should be determined by expectations
about the future of an economy, not current trade
flows
Since the prospect of an economy is reflected on the
demand of financial assets in that economy, the asset
market approach believes that changes of exchange
rates are affected by changes of the supply and
demand for a wide variety of financial assets:
Shifts in the supply and demand for financial assets alter
exchange rates (not the demand and supply of financial
assets determine the exchange rate)
The asset market approach is also called the relative price of
bonds or portfolio balance approach

10-14
Exchange Rate Determination:
The Theoretical Thread
More specifically, if the demand for domestic financial assets
increases, the demand for the domestic currency will increase,
which could results in the appreciation of the domestic
currency
Changes in monetary and fiscal policy alter expected returns
and perceived relative risks of financial assets, which in turn
alter the demand and supply of financial assets and thus
exchange rates (In the 1980s, many macroeconomic theories
focused on this topic)
Later I will introduce the determining factors in the asset
market approach in detail
10-15
Exchange Rate Determination:
The Theoretical Thread
Technical analysis is based on the belief that the
study of past price behaviors provides insights into
future price movements
Due to the poor forecasting performance of many
fundamental theories, the technical analysis draws more
attention and becomes popular
The primary assumption of the technical analysis is that the
movements of any market driven price (e.g., exchange
rates) must follow trends
More specifically, technical analysts, traditionally referred
to as chartists, focus on price and volume data to identify
trends that are expected to continue into the future and next
exploit trends to make profit

10-16
The Asset Market
Approach to Forecasting
10-17
The Asset Market Approach
to Forecasting
The asset market approach assumes that the motives of
foreigners to hold claims in one currency depends on
an extensive set of investment considerations or
drivers:
1. Relative real interest rates (an important concern for
investing in foreign bonds and money market instruments)
2. Prospects for economic growth (the major reason for cross-
border equity investment and foreign direct investment)
3. Capital market liquidity (Cross-border investors are not
only interested in investing assets to earn higher returns, but
also in being able to sell assets quickly for fair market value)
4. A countrys economic and social infrastructure (which is
an indicator of that countrys ability to survive in unexpected
external stocks)
10-18
The Asset Market Approach
to Forecasting
5. Political safety (which is usually reflected in political risk
premiums for a countrys securities)
6. Corporate governance practices (poor corporate governance
practices can reduce the investing will of foreign investors)
7. Contagion (which is the spread of a crisis in one country to its
neighboring countries, and can cause an innocent country to
experience capital flight and a resulting depreciation of its
currency)
8. Speculation (can cause a foreign exchange crisis or make an
existing crisis worse)
In summary, the asset market approach believes that the above
factors affect the motives of investments from both domestic
and foreign investors and thus affect the exchange rate
10-19
The Asset Market Approach
to Forecasting
Foreign investors are willing to hold securities and
undertake foreign direct or portofolio investment in
highly developed countries based primarily on
relative real interest rates and the outlook for
economic growth and profitability
The experience of the U.S. illustrates why some
forecasters believe that exchange rates are more
heavily influenced by economic prospects than by the
current account
For 1981-1985, the US$ strengthened despite growing
current account deficits
Relatively high real interest rates and good long-run prospects
cause heavy capital inflow into the U.S.
10-20
The Asset Market Approach
to Forecasting
For 1990-2000, the US$ strengthened despite continued
worsening balances on current account
The US$ remained to be strong due to foreign capital inflow
motivated by rising stock and real estate prices, a low rate of
inflation, high real interest rates, and an irrational expectation
about future economic prospects
Actually, from 1995 to 2001, the Nasdaq index increased by a
factor of more than 6
After the terrorists attacked the U.S. on September 11, 2001
A negative reassessment of long-term prospects due to the
newly formed political risk in the U.S.
The drop of the stock markets and a series of failures in
corporate governance of large corporations further led to a large
withdrawal of foreign capital from the U.S.
According to both the BOP approach and the asset market
approach, the US$ depreciated since then
10-21
Illustrative Cases in
Emerging Markets
10-22
Disequilibrium: Exchange Rates
in Emerging Markets
The asset market approach is also applicable to
emerging markets, however, not only the relative real
interest rates and the prospects for economic growth
but also additional factors contribute to exchange rate
determination (see Slides 10-18 and 10-19)
The Asian and Argentine crises are examined as illustrative
cases in this section


10-23
Illustrative Case:
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 due to the following two
reasons
Rapidly economic expansion
Many Asian countries pegged its currency at a fixed
exchange rate with the US$, so their currencies appreciated
with the US$ being strong after 1995
The deficit of BOP generates the depreciation pressure
To support their pegged exchange rates, Asian nations
require to attract net capital inflow
The most visible roots of the crisis were the excess capital
inflows into Thailand in 1996 and early 1997
10-24
Illustrative Case:
The Asian Crisis of 1997
Thai banks continued to raise capital internationally,
and extended credit to a variety of domestic investments
and enterprises beyond what the Thai economy could
support
As the investment bubble expanded, market
participants questioned the ability of the economy to
repay the rising amount of debt, so the Thai baht was
attacked by international speculation CFs (factor 8)
The Thai government intervened directly (using up
precious currency reserves) and indirectly by raising
interest rates in support of the currency (to stop the
continual outflow)
On July 2, 1997, the Thai central bank allowed the baht
to float, and the Thai baht against US$ fell 17% in
several hours and 38% in 4 months


10-25
Illustrative Case:
The Asian Crisis in 1997
The international speculators attacked a number of
neighboring Asian nations, some with and some
without characteristics similar to Thailand (factor 7)
It is the Asias own version of the tequila effect
Tequila effect is the term used to describe how the
Mexican peso crisis of December 1994 quickly spread to
other Latin American currency and equity markets
The spread of the financial panic is termed contagion
The Philippine peso, the Malaysian ringgit, and
Indonesian rupiah all fell in the months following
the July baht devaluation
10-26
Exhibit 10.3 Comparative Daily
Exchange Rates: Relative to the US$
10-27
Exhibit 10.2 The Economies and
Currencies of Asia, JulyNovember 1997
Due to the not-completely-free-convertible features, the Chinese yuan was not
devalued, but there was rising speculation that Chinese government would devalue it
soon for competitive reasons (but it did not)
The Hong Kong dollar survived, but with great expense to the central banks foreign
exchange reserves
Although Taiwan was with enough foreign exchange reserves, Taiwan caught the
markets imbalance with a surprise competitive depreciation of 15% in Oct. 1997
10-28
Illustrative Case:
The Asian Crisis of 1997
The Asian economic crisis (which was much more
than just a currency collapse) had other reasons besides
traditional balance of payments difficulties:
Corporate socialism
In Asia, because the influence of governments, even in the
event of failure, it was believed that governments would not
allow firms to fail, banks to close, and workers to lose their jobs
This kind of policy provided the stability of the economy, but
when business liabilities exceeded the capacities of
governments to bail businesses out, the crisis happened
Overinvestment in Asian countries (factor 2)
Due to the low interest rate in both Japan and the U.S., too
much capital for portfolio investments flowed into Asian
countries, which supports the bubble in Asian countries
Banking liquidity and management (factors 3, 4, and 6)
The lack of transparency and monitoring mechanisms
encouraged banks to underestimate the credit risk of firms and
expand the lending business too much



10-29
Illustrative Case:
The Asian Crisis of 1997
Banks did not hedge exchange rate risk while raising
international capital, so when the domestic currency depreciated
in the financial crisis, they suffered further loss
During the financial crisis, banks themselves suffer the liquidity
problem, so banks cannot provide liquidity to firms for
conducing their businesses
Political risk (factor 5)
Investors did not have confidence in the political stability of
southeast Asian countries. So, if there is any sign for political
problems, the capital out flowed from those countries
immediately
After the crisis, the slowed economies of this region
quickly caused major reductions in world demands for
many commodities and thus the decline of the
commodity prices, e.g., oil, metal, agricultural
products, etc., which is part of the reasons for the
Russian crisis in 1998
10-30
Illustrative Case:
The Argentine Crisis of 2002
In order to eliminate the hyperinflation problem that
had undermined the nations standard of living in
the 1980s, a currency board structure was
implemented in Argentina in the early 1990s
In 1991, the Argentine peso had been fixed to the US
dollar at a one-to-one rate of exchange
The reason why the currency board regime can
control the inflation problem:
Limit the growth rate in the countrys currency supply to
the rate at which the country receives net inflows of U.S.
dollars as a result of trade growth and general surplus
This rigorous restriction eliminates the power of politicians
to affect the currency policy in both good and bad ways,
e.g., the government lost the ability to utilize the monetary
policy to stimulate the economy 10-31
Illustrative Case:
The Argentine Crisis of 2002
Although the hyperinflation was cured by the restrictive monetary
policy, this policy also slowed economic growth in the coming years
The real GDP shrank in 1999 (-3.5%) and 2000 (-0.4%), and the
unemployment rate rose to about 15% since 1995
In order to demonstrate the governments unwavering
commitment to maintaining the pesos value parity with
the dollar, the Argentine government allowed banks to
accept deposits in either pesos and dollars
However, there was substantial doubt in the market that
the Argentine government was able to maintain the fixed
exchange rate

10-32
Illustrative Case:
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 (factor 2)
The inability of the pesos value to change with the market
forces (e.g., economic growth, competitive power of firms, and
so on) led many to believe increasingly that it was overvalued
Argentine exports became some of the most expensive in all of
south America, as other countries depreciated their currencies
against the US$ over the decade, but not the Argentine peso
Therefore, the deficit of the current account deteriorated from
$0.65 billion (in 1991) to $8.9 billion (in 2000)
10-33
Illustrative Case:
The Argentine Crisis of 2002
The currency board regime had eliminated monetary policy
alternatives for macroeconomic policy
The rule of the currency board regime eliminated monetary policy
as an avenue for macroeconomic policy formulation, leaving only
fiscal policies (e.g., government spending and tax policy) for
economic stimulation
In fact, due to the continuous deficit of the BOP, Argentina could
only adopt the contraction monetary policy from 1991 to 2000
The Argentine government budget deficit, i.e., spending, was
out of control
As the unemployment rate grew higher, as poverty and social
unrest grew, government spending continued to increase to solve
these social and economic problems
Without the proportional increase of tax receipts, Argentine
government then turned to raise international debts to aid in the
financing of its spending (the total foreign debt had double from
1991 to 2000)
10-34
Illustrative Case:
The Argentine Crisis of 2002
As economic conditions continued to deteriorate,
depositors, fearing that the peso would be devalued,
withdrew their peso cash balances and then
converted pesos to US$, which speeded up the
currency collapse
The government, fearing that the increasing financial
drain on banks would cause their collapse, close the
banks on December 1, 2001 to stop the flight of
capital out of Argentina
During the political chaos in the beginning of 2002
(factor 5), Argentina declared the largest sovereign
debt default in history that it would not be able to
make interest payments due on $155 billion in
sovereign (government) debt
10-35
Illustrative Case:
The Argentine Crisis of 2002
On January 6, 2002, the Argentine government
decided that the peso was devalued from Ps1.00/$ to
Ps1.40/$ 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 (factor 3)
The provincial governments began printing their all
money, promissory notes
Because the notes were issued by the provincial
governments, not the federal government, people and
business would not accept notes form other provinces

10-36
Illustrative Case:
The Argentine Crisis of 2002
The population became trapped within its own province,
because their money was not accepted in the outside
world in exchange for goods, services, travel, or
anything else
On February 3, 2002, the Argentine government
announced that the peso would be floated and the banks
would reopen
In February and March 2002, negotiations between the
IMF and Argentina continued as the IMF demanded
increasing fiscal reform over the growing government
budget deficits and bank mismanagement (factor 4)
Argentinas experience has proved that it is not easy to
adopt the currency board system of a firmly fixed
exchange rate for an economy


10-37
Forecasting in Practice
10-38
Forecasting in Practice
Although the three different schools of thought on
exchange rate determination (parity conditions,
balance of payments approach, asset market approach)
make understanding exchange rates to be
straightforward, that is 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 these
theories or need to be explained by considering more factors
(see the illustrative cases in the previous section)
As a consequence, numerous foreign exchange
forecasting services exist, many of which are provided
by banks and independent consultants
10-39
Forecasting in Practice
Some multinational firms have their own in-house
forecasting capabilities
Long-term forecasts may be motivated by a multinational
firms desire to initiate a foreign investment
Short-term forecasts are typically motivated by a desire to
hedge account receivables or payable for perhaps a period of
several months
Predictions can be based on fundamental theories
(usually used for long-term forecasts), various
econometric models (e.g., time series techniques which
infer no theory but simply try to find relation between
future values and the past values), or technical analysis
of charts and trends (more suitable for short-term
forecasts)
10-40
Forecasting in Practice
In technical analysis, exchange rate movements, similar
to equity price movements, can be divided into three
components:
Day-to-day movements (seemingly random)
Short-term movements from several days to several months
(temporarily deviations from the long-term trend)
Long-term trends
Forecasting for the long-run exchange rate movement can
depends on the economic fundamentals of exchange rate
determination, i.e., the inflation rates, interest rates, or the
prospects of economies
Many researches suggest that the long-term exchange rate
exhibits the characteristic of mean reversion, i.e., the exchange
rates eventually move back towards the mean or average
10-41
Forecasting in Practice
In practice, a synthesis of the exchange rate forecast is
often adopted
From many theoretical and empirical studies, long-term
exchange rates do adhere to the fundamental principles and
theories outlined in the previous sections Fundamental
principles do apply in the long term There exists a
fundamental equilibrium path for a currencys value
In the short term, a variety of random events called noise
may cause currency values to deviate from their long-term
fundamental equilibrium path


10-42
Exhibit 10.8 Differentiating Short-Term
Noise from Long-Term Trends
Time
Foreign currency per
unit of domestic currency
Fundamental
Equilibrium
Path
Political or social events or weak
infrastructure (e.g., the banking system)
may drive the exchange
rate from the long-term path significantly
Short-term forces may induce
noiseshort-term volatility
around the long-term path

The long-term equilibrium path is not always apparent in the short term
(although relatively well-defined in retrospect)
Some studies also point out that the exchange rate itself may deviate in
something of a cycle or wave about the long-term path
10-43
Exhibit 10.7 Exchange Rate
Forecasting in Practice
10-44
financial condition
JPMorgan Chases Forecasting
Accuracy (US$/)
10-45
The above figure shows the forecast of JPMorgan Chase for the 90-day
US$/ exchange rate into the future
In February of 2004, it forecasted the exchange rate to move from $1.27/ to
$1.32/ , but in fact the realized exchange rate after 90 days is $1.19/ , which
illustrates the difficulty to forecast the movement of the exchange rate
Forecasting in Practice
Predict exchange rate dynamics
Although various theories surrounding exchange rate
determination are clear and sound, the difficulty is to
understand which fundamental theories are driving markets
at which time points
One example over exchange rate dynamics is the
phenomenon known as overshooting
The U.S. Federal Reserve announces an expansionary monetary
policy, and the markets react to this news through the
immediate depreciation in the exchange rate from S
0
to S
1
(According to the asset market approach, currency supply
real interest rate of US$ capital outflow from the U.S.
US$ depreciates)
With the passing of time, the price impact of this monetary
policy starts working through the economy to increase the price
level. According to PPP, the equilibrium exchange rate, i.e., the
exchange rate in the long run, should depreciate to be S
2


10-46
Exhibit 10.9 Exchange Rate Dynamics:
Overshooting
S
0
t
1
t
2
S
1
S
2
Spot Exchange
Rate ($/ )
Overshooting
Time
The difference between S
1
and S
2
reflects the dominance of different
theoretical principles at different points in time (first is the asset market
approach and second is the PPP theory)
As a result, the initial higher value of S
1
is often explained as an
overshooting of the longer-term equilibrium value of S
2
Since the exchange rate is expressed as
US$ price per euro, S
1
> S
0
(S
2
> S
0
)
represents the depreciation of the US
dollars against the euros

10-47