UNIT II

Exchange Rate Determination &

Factors Forecasting
Exchange Rate Forecasting
 To know, how the rate of exchange between
two currencies are decided

 What are the factors making one currency

stronger or weaker against another

 There are various models or theories given for

this purpose
Exchange Rate Forecasting

Process of predicting future

exchange prices between two
countries on the basis of
various factors affecting.
Exchange Rate Forecasting
Need
 Hedging Decision

 Investment in Short-Term of Funds

 Long-Term Investment of Funds

 Financing Decision

 Assessment of Earning
 Exchange Rate Forecasting
Techniques

Technical Fundamental Market-Based Mixed

Forecasting Forecasting Forecasting Forecasting
•Based on Past Data •Based on •Based on Market •Mixture of all the
•Charting Fundamentals i.e. Movements of above
•Moving Averages Macro Economic Technical Forecast
•Trending Variables like and Fundamental
•Mathematical Tech. inflation, interest Forecast
rate, economy
status
Exchange Rate Forecasting
Theories and Models
 Mainly based on two factors
 Inflation
 Interest Rates

 Divided in two categories

 Structured
 Unstructured
Exchange Rate Forecasting
Theories and Models
Models or Theories of Exchange Rate Determination

Non-Structured Models of Exchange Structured Models of Exchange Rate

Rate Determination Determination

Purchasing
Power Parity
Model Balance of Assets Market
Payment Model
Approach
Interest Rate
Parity Model

Monetary Portfolio
Approach Balance
Approach
Exchange Rate Forecasting
1. Purchasing Power Parity (PPP)

INDIA – INR (Rs.) USA ($)

Price of 100 Price of 100

Kg Wheat – Kg Wheat –

Rs.10000 $ 200
Rs.10000 = 100 Kg Wheat = $200
Rs.10000 = $200
Rs. / $ = 10000 / 200
Rs. / $ = 50
Exchange Rate Forecasting
1. Purchasing Power Parity (PPP)
 If ‘e’ is the exchange rate
 PA and PB are the purchasing power of two
currencies A and B
 Exchange rate between them should satisfy
the equation which can be written as:

e = PA / PB
Exchange Rate Forecasting
1. Purchasing Power Parity (PPP)

 It was the ‘Absolute Version’ of PPP, which

tells the rate of exchange

 Another version i.e. ‘Relative Version’ of PPP

tells us about the future change in exchange
rate
Exchange Rate Forecasting
1. Purchasing Power Parity (PPP)

INDIA – INR (Rs.) USA ($)

Price of 100 Price of 100

Kg Wheat – Kg Wheat –

Rs.10000 $ 250
Rs.10000 = 100 Kg Wheat = $250
Rs.10000 = $250
Rs. / $ = 10000 / 250
Rs. / $ = 40
Exchange Rate Forecasting
1. Purchasing Power Parity (PPP)
 It states that the exchange rate between the
home currency and any foreign currency will
adjust to reflect changes in the price levels
(inflation) of the two countries.

 That means if inflation is 5% in India and 3% in

USA, then in order to equalize the price of
goods in the two countries, the value of US $
must rise about 2%
Exchange Rate Forecasting
1. Purchasing Power Parity (PPP)
 Future Rate = (Current Rate x Adjustment
for different in inflation)

 If Current Spot Price is : e0

 Inflation in home country is: ih
 Inflation in foreign country is: If
 Then, future exchange rate after time t (e t)
(1  ih ) t
et  e 0
(1  i f ) t
Exchange Rate Forecasting
1. Purchasing Power Parity (PPP)
 Although theory holds good in long-run

 Still, face some criticism like

 There are some other factors like interest

rate which affects exchange rates.
Exchange Rate Forecasting
2. Interest Rate Parity (IRP)
 This theory is used to forecast the exchange
rate of forward market

As per this theory:

Forward Rate Differential = Interest Rate
Differential
Exchange Rate Forecasting
2. Interest Rate Parity (IRP)
As per this theory:
Forward Rate Differential = Interest Rate
Differential
( Fn  S )
Forward Rate Differential  A
S

(1  I A )
Interest Rate Differenti al  1
(1  I B )
Exchange Rate Forecasting
2. Interest Rate Parity (IRP)
As per this theory:
Forward Rate Differential = Interest Rate
Differential
( Fn  S ) (1  I A )
A  1
S (1  I B )

S (1  I A )
Fn   [{  1} ]  S
A (1  I B )
Exchange Rate Forecasting
2. Interest Rate Parity (IRP)
 Example: Suppose Interest Rate in
USA (Country A) is 10% and Interest
rate in India (Country B) is 7%.
Current Spot Rate (Rs./$) is 40.00.
Therefore, 3 months forward will be:

 F3 = 40/4 {(1.10 / 1.07) – 1} + 40

 = 40.28 US $
Exchange Rate Forecasting
2. Interest Rate Parity (IRP)
 Some of the Criticism of this approach are:
 Different Rate Prevails

 Investment in foreign assets is risky

 Practically, it is future market expectations

which affects the forward rates
Exchange Rate Forecasting
STRUCTURAL MODELS
 As we know, it is mainly demand and
supply of a currency which impacts the
rates

 Demand and Supply is judged on the basis

of future economic changes

 Structural Methods finds rates on these

considerations
Exchange Rate Forecasting
1. Balance of Payment Approach
 It suggests that an increase in domestic
price level over the foreign price level makes
foreign goods cheaper.
 It decreases the exports and increases the
imports which results in deficit in Balance of
Payment
 And depreciates the domestic currency.
Exchange Rate Forecasting
1. Balance of Payment Approach
 Similarly, growth in real national income
also causes larger imports, thereby
depreciating domestic currency.

 Increase in domestic interest rate on the

other hand causes capital inflow that
increases the supply of foreign exchange
and thereby causes appreciation in the value
of domestic currency
 Exchange Rate Forecasting
2. Assets-Market Model
 MONETARY APPROACH:

If Increase in
Demand > Increase Price (Inflation) Fall in Domestic
in Output Rises Currency’s value
Increase in Increase in
Money Supply Demand
If Increase in Price (Inflation) Rise in Domestic
Demand < Increase
Falls Currency’s value
in Output
Exchange Rate Forecasting
2. Assets-Market Model
 PORTFOLIO APPROACH:
Exchange Rate Forecasting
2. Assets-Market Model
 MONETARY APPROACH:
 This approach suggests that not only monetary

factors but holding of different financial assets

also impact rates

 Due to change in domestic and foreign interest

rates portfolio get changes and creates inflows
and outflows of currency

 Cause change in demand & supply i.e. rates

International Trade Theories

Why does Nations Trade?