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

Foreign Exchange Rate
Determination
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
Exhibit 10.1 The
Determinants of Foreign
Exchange Rates
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


Exchange Rate
Determination: The
Theoretical Thread
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
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
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
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
to PPP, domestic currency depreciates
2. Domestic currency supply growth rate
> foreign currency supply growth rate
domestic currency depreciates vs.
foreign currency
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
PPP, domestic currency depreciates
2. Increase of domestic 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
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
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

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
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

The Asset Market
Approach to Forecasting
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)
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
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.
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
Illustrative Cases in
Emerging Markets
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


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
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


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
Exhibit 10.3 Comparative
Daily Exchange Rates:
Relative to the US$
Exhibit 10.2 The Economies
and Currencies of Asia, July
November 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
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



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
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
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

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 $8.9 billion (in 2000)
Illustrative Case:
The Argentine Crisis of
2002
The currency board regime had
eliminated monetary policy alternatives
for macroeconomic policy
The rule of the currency board regime
eliminated monetary policy as an
avenue for macroeconomic policy
formulation, leaving only fiscal policies
(e.g., government spending and tax
policy) for economic stimulation
In fact, due to the continuous deficit of
the BOP, Argentina could only adopt the
contraction monetary policy from 1991
to 2000
The Argentine government budget
deficit, i.e., spending, was out of control
As the unemployment rate grew higher,
as poverty and social unrest grew,
government spending continued to
increase to solve these social and
economic problems
Without the proportional increase of tax
receipts, Argentine government then
turned to raise international debts to aid
in the financing of its spending (the total
foreign debt had double from 1991 to
2000)
Illustrative Case:
The Argentine Crisis of
2002
As economic conditions continued to
deteriorate, depositors, fearing that
the peso would be devalued,
withdrew their peso cash balances
and then converted pesos to US$,
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 $155 billion in
sovereign (government) debt
Illustrative Case:
The Argentine Crisis of
2002
On January 6, 2002, the Argentine
government decided that the peso
was devalued from Ps1.00/$ 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

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


Forecasting in Practice
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
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)
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
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


Exhibit 10.8 Differentiating
Short-Term Noise from Long-
Term Trends
Exhibit 10.7 Exchange
Rate Forecasting in
Practice
JPMorgan Chases
Forecasting Accuracy
(US$/)
Forecasting in Practice
Predict exchange rate dynamics
Although various theories surrounding
exchange rate determination are clear
and sound, the difficulty is to
understand which fundamental
theories are driving markets at which
time points
One example over exchange rate
dynamics is the phenomenon known as
overshooting
The U.S. Federal Reserve announces an
expansionary monetary policy, and the
markets react to this news through the
immediate depreciation in the exchange
rate from S
0
to S
1
(According to the
asset market approach, currency
supply real interest rate of US$
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


Exhibit 10.9 Exchange Rate
Dynamics: Overshooting