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 CHAPTER 9

FOREIGN EXCHANGE RATE DETERMINATION

1. Exchange Rate Determination. What are the three basic theoretical approaches to exchange rate
determination?

The three major schools of thought are (1) purchasing power parity, (2) balance of payments
approach, and (3) asset market approach.

Purchasing Power Parity Approach. The most widely accepted of all exchange rate determination
theories, the theory of purchasing power parity (PPP) states that the long-run equilibrium exchange
rate is determined by the ratio of domestic prices relative to foreign prices, as explained in Chapter 6.
PPP is both the oldest and most widely followed of the exchange rate theories, and most theories of
exchange rate determination have PPP elements embedded within their frameworks.

Balance of Payments Approach. After PPP, the most frequently used theoretical approach to
exchange rate determination is probably that involving the supply and demand for currencies in the
foreign exchange market. These exchange rate flows reflect current account and financial account
transactions recorded in a nation’s balance of payments, as described in Chapter 3. The basic balance
of payments approach argues that the equilibrium exchange rate is found when the net inflow
(outflow) of foreign exchange arising from current account activities matches the net outflow (inflow)
of foreign exchange arising from financial account activities.

Asset Market Approach. The asset market approach, sometimes called the relative price of bonds
or portfolio balance approach, argues that exchange rates are determined by the supply and demand
for financial assets of a wide variety. 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 rates.

2. PPP Inadequacy. The most widely accepted theory of foreign exchange rate determination is
purchasing power parity, yet it has proven to quit poor at forecasting future spot exchange rates.
Why?

Although PPP seems to possess a core element of common sense, it has proven to be quite poor at
forecasting exchange rates (at least in the short to medium term). The problems are both theoretical
and empirical. The theoretical problems lie primarily with its basic assumption that the only thing that
matters is relative price changes. Yet many currency supply and demand forces are driven by other
forces, including investment incentives, economic growth, and political change. The empirical issues
are primarily in deciding which measures or indexes of prices to use across countries, in addition to
the ability to provide a “predicted change in prices” with the chosen indexes.

3. Data and the Balance of Payments Approach. Statistics on a country’s balance of payments are
used by the business press and business itself often in terms of predicting exchange rates, but the
academic profession is highly critical of it. Why?

Criticisms of the balance of payments approach arise from the theory’s emphasis on flows of currency
and capital rather than on stocks of money or financial assets. Relative stocks of money or financial

© 2016 Pearson Education, Inc.

 Chapter 9 Foreign Exchange Rate Determination ▪ 49

assets play no role in exchange rate determination in this theory, a weakness explored in the following
discussion of monetary and asset market approaches. Curiously, while the balance of payments
approach is largely dismissed by the academic community today, the practitioner public-market
participants, including currency traders themselves, still rely on different variations of this theory for
much of their decision making.

4. Supply and Demand. Which of the three major theoretical approaches seems to put the most weight
into arguments on the supply and demand for currency? What is its primary weakness?

The monetary approach focuses on changes in the supply and demand for money as the primary
determinant of inflation. Changes in relative inflation rates in turn are expected to alter exchange rates
through a purchasing power parity effect. The monetary approach then assumes that prices are
flexible in the short run as well as the long run, so that the transmission mechanism of inflationary
pressure is immediate in impact.

A weakness of monetary models of exchange rate determination is that real economic activity is
relegated to a role in which it only influences exchange rates through changes in the demand for
money. The monetary approach is also criticized for its omission of a number of factors that are
generally agreed upon by area experts as important to exchange rate determination, including (1) the
failure of PPP to hold in the short to medium term; (2) money demand appears to be relatively
unstable over time; and (3) the level of economic activity and the money supply appear to be
interdependent, not independent.

5. Asset Market Approach to Forecasting. Explain how the asset market approach can be used to
forecast future spot exchange rates. How does the asset market approach differ from the BOP
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. These drivers include the
following:

▪ Relative real interest rates are a major consideration for investors in foreign bonds and short-term
money market instruments.
▪ Prospects for economic growth and profitability are an important determinant of cross-border
equity investment in both securities and foreign direct investment.
▪ Capital market liquidity is particularly important to foreign institutional investors. Cross-border
investors are not only interested in the ease of buying assets, but also in the ease of selling those
assets quickly for fair market value if desired.
▪ A country’s economic and social infrastructure is an important indicator of that country’s ability
to survive unexpected external shocks and to prosper in a rapidly changing world economic
environment.
▪ Political safety is exceptionally important to both foreign portfolio and direct investors. The
outlook for political safety is usually reflected in political risk premiums for a country’s securities
and for purposes of evaluating foreign direct investment in that country.
▪ The credibility of corporate governance practices is important to cross-border portfolio investors.
A firm’s poor corporate governance practices can reduce foreign investors’ influence and cause
subsequent loss of the firm’s focus on shareholder wealth objectives.
▪ Contagion is defined as the spread of a crisis in one country to its neighboring countries and other
countries that have similar characteristics—at least in the eyes of cross-border investors.
Contagion can cause an “innocent” country to experience capital flight with a resulting
depreciation of its currency.

© 2016 Pearson Education, Inc.

50 ▪ Eiteman/Stonehill/Moffett | Multinational Business Finance, 14th Edition

▪ Speculation can cause a foreign exchange crisis, make an existing crisis worse, or both. We will
observe this effect through the three illustrative cases that follow shortly.

6. Technical Analysis. Explain how technical analysis can be used to forecast future spot exchange
rates. How does technical analysis differ from the BOP and asset market approaches to forecasting?

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. The single most important element of
technical analysis is that future exchange rates are based on the current exchange rate. Exchange rate
movements, similar to equity price movements, can be subdivided into three periods: (1) day-to-day
movement, which is seemingly random; (2) short-term movements extending from several days to
trends lasting several months; and (3) long-term movements, which are characterized by up and down
long-term trends. Long-term technical analysis has gained new popularity as a result of recent
research into the possibility that long-term “waves” in currency movements exist under floating
exchange rates.

7. Intervention. What is foreign currency intervention? How is it accomplished?

Foreign currency intervention is the active management, manipulation, or intervention in the

market’s valuation of a country’s currency. A short list of the intervention methods would include
direct intervention, indirect intervention, and capital controls.

Direct Intervention. This is the active buying and selling of the domestic currency against foreign
currencies. This traditionally required a central bank to act like any other trader in the currency
market—albeit a big one. If the goal were to increase the value of the domestic currency, the central
bank would purchase its own currency using its foreign exchange reserves, at least to the acceptable
limits that it could endure depleting its reserves.

Indirect Intervention. This is the alteration of economic or financial fundamentals that are thought
to be drivers of capital to flow in and out of specific currencies. This was a logical development for
market manipulation given the growth in size of the global currency markets relative to the financial
resources of central banks.

8. Intervention Motivation. Why do governments and central banks intervene in the foreign exchange
markets? If markets are efficient, why not let them determine the value of a currency?

Historically, a primary motive for a government to pursue currency value change was to keep the
country’s currency cheap so that foreign buyers would find its exports cheap. This policy, long
referred to as “beggar-thy-neighbor,” gave rise to many competitive devaluations over the years. It
has not, however, fallen out of fashion.

Alternatively, the fall in the value of the domestic currency will sharply reduce the purchasing power
of its people. If the economy is forced, for a variety of reasons, to continue to purchase imported
products (e.g., petroleum imports because of no domestic substitute), a currency devaluation or
depreciation may prove highly inflationary and, in the extreme, impoverish the country’s people (as
in the case of Venezuela).

It is frequently noted that most countries would like to see stable exchange rates and to avoid the
entanglements associated with manipulating currency values. Unfortunately, that would also imply
that they are also happy with the current exchange rate’s impact on country-level competitiveness.

© 2016 Pearson Education, Inc.

 Chapter 9 Foreign Exchange Rate Determination ▪ 51

9. Direct Intervention Usefulness. When is direct intervention likely to be the most successful? And
when is it likely to be the least successful?

Direct intervention was the primary method used for many years, but beginning in the 1970s, the
world’s currency markets grew enough that any individual player, even a central bank, could find
itself with insufficient resources to move the market.

10. Intervention Downside. What is the downside of both direct and indirect intervention?

It is important to remember that intervention may—and often does—fail. The Turkish currency crisis
of 2014 is a classic example of a drastic indirect intervention that ultimately only slowed the rate of
capital flight and currency collapse. Turkey had enjoyed some degree of currency stability throughout
2012 and 2013, but the Turkish economy (one of the so-called “Fragile Five” countries, along with
South Africa, India, Indonesia, and Brazil) suffered a widening current account deficit and rising
inflation in late 2013. With the increasing anxieties in emerging markets in the fourth quarter of 2013
over the U.S. Federal Reserve’s announcement that it would be slowing its bond purchasing (the
Taper Program, essentially a tighter monetary policy), capital began exiting Turkey. The lira came
under increasing downward pressure.

11. Capital Controls. Are capital controls really a method of currency market intervention, or more of a
denial of activity? How does this fit with the concept of the impossible trinity?

This is the restriction of access to foreign currency by government. This involves limiting the ability
to exchange domestic currency for foreign currency. When access and exchange is permitted, trading
takes place only with official designees of the government or central bank, and only at dictated
exchange rates.

Often, governments will limit access to foreign currencies to commercial trade: for example, allowing
access to hard currency for the purchase of imports only. Access for investment purposes—
particularly for short-term portfolios in which investors are moving in and out of interest-bearing
accounts, purchasing or selling securities or other funds—is often prohibited or limited. The Chinese
regulation of access and trading of the Chinese yuan is a prime example of the use of capital controls
over currency value—a choice within the framework of the Impossible Trinity. In addition to the
government’s setting the daily rate of exchange, access to the exchange is limited by a difficult and
timely bureaucratic process for approval and is limited to commercial trade transactions.

12. Asian Crisis of 1997 and Disequilibrium. What was the primary disequilibrium at work in Asia in
1997 that likely caused the Asian financial crisis? Do you think it could have been avoided?

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. Starting as
early as 1990 in Thailand, the rapidly expanding economies of the Far East began importing more
than they exported, requiring major net capital inflows to support their currencies. As long as the
capital continued to flow in—capital for manufacturing plants, dam projects, infrastructure
development, and even real estate speculation—the pegged exchange rates of the region could be
maintained. When the investment capital inflows stopped, however, crisis was inevitable.

Many analysts argue that if the governments of these Far East nations had given up their pegged
exchange rates earlier, the market adjustment would have been made gradually over time as their
economies changed. Expecting governments to give up on pegged exchange rates, particularly when
they still viewed their economic life-blood to be exports, is not, however, very realistic.

© 2016 Pearson Education, Inc.

52 ▪ Eiteman/Stonehill/Moffett | Multinational Business Finance, 14th Edition

13. Fundamental Equilibrium. What is meant by the term “fundamental equilibrium path” for a
currency value? What is “noise”?

It appears from decades of theoretical and empirical studies that exchange rates do adhere to the
fundamental theories outlined in this chapter (namely purchasing power parity and interest rate
parity). Fundamentals do apply in the long term. There is, therefore, something of a fundamental
equilibrium path for a currency’s value.

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 is sometimes referred to as noise. Clearly, therefore, we might expect deviations from the long-
term path not only to occur, but to occur with some regularity and relative longevity.

14. Argentina’s Failure. What was the basis of the Argentine Currency Board, and why did it fail in
2002?

By 2001, crisis conditions had revealed three very important underlying problems with Argentina’s
economy: (1) the Argentine peso was overvalued; (2) the currency board regime had eliminated
monetary policy alternatives for macroeconomic policy; and (3) the Argentine government budget
deficit, and deficit spending, was out of control.

The peso had indeed been stabilized. But inflation had not been eliminated, and the other factors that
are important in the global market’s evaluation of a currency’s value—economic growth, corporate
profitability, etc.—had not necessarily always been positive. The inability of the peso’s value to
change with market forces led many to believe increasingly that it was overvalued and that the
overvaluation gap was rising as time passed.

Argentina’s large neighbor to the north, Brazil, had also suffered many of the economic ills of
hyperinflation and international indebtedness in the 1980s and early 1990s. Brazil’s response, the
Real Plan, was introduced in July 1994. The real plan worked, for a while, but eventually collapsed in
January 1999 as a result of the rising gap between the real’s official value and the market’s
assessment of its true value.

Brazil was by far Argentina’s largest trading partner. With the fall of the Brazilian real, however,
Brazilian consumers could no longer afford Argentine exports. It simply took too many real to
purchase a peso. In fact, Argentine exports became some of the most expensive in all of South
America as other countries saw their currencies slide marginally against the dollar over the decade but
the Argentine peso did not slide.

15. Term Forecasting. What are the major differences between short-term and long-term forecasts for a
fixed exchange rate versus a floating exchange rate?

Long-run forecasts may be motivated by a multinational firm’s desire to initiate a foreign investment
in Japan, or perhaps to raise long-term funds denominated in Japanese yen. Or a portfolio manager
may be considering diversifying for the long term in Japanese securities. The longer the time horizon
of the forecast, the more inaccurate but also the less critical the forecast is likely to be. The forecaster
will typically use annual data to display long-run trends in such economic fundamentals as Japanese
inflation, growth, and the BOP.

Short-term forecasts are typically motivated by a desire to hedge a receivable, payable, or dividend
for perhaps a period of three months. In this case, the long-run economic fundamentals may not be as

© 2016 Pearson Education, Inc.

 Chapter 9 Foreign Exchange Rate Determination ▪ 53

important as technical factors in the marketplace, government intervention, news, and passing whims
of traders and investors. Accuracy of the forecast is critical because most of the exchange rate
changes are relatively small even though the day-to-day volatility may be high.

Forecasting services normally undertake fundamental economic analysis for long-term forecasts, and
some base their short-term forecasts on the same basic model. Others base their short-term forecasts
on technical analysis similar to that conducted in security analysis. They attempt to correlate
exchange rate changes with various other variables, regardless of whether there is any economic
rationale for the correlation. The chances of these forecasts being consistently useful or profitable
depends on whether one believes the foreign exchange market is efficient. The more efficient the
market is, the more likely it is that exchange rates are “random walks,” with past price behavior
providing no clues to the future. The less efficient the foreign exchange market is, the better the
chance that forecasters may get lucky and find a key relationship that holds, at least for the short run.
If the relationship is really consistent, however, others will soon discover it, and the market will
become efficient again with respect to that piece of information. Exhibit 9.9 summarizes the various
forecasting periods, regimes, and the authors’ opinions on the preferred methodologies.

16. Exchange Rate Dynamics. What is meant by the term “overshooting”? What causes it, and how is it
corrected?

Assume that the current spot rate between the dollar and the euro, as illustrated in Exhibit 9.9 in the
text, is S0. The U.S. Federal Reserve announces an expansionary monetary policy that cuts U.S. dollar
interest rates. If euro-denominated interest rates remain unchanged, the new spot rate expected by the
exchange markets on the basis of interest differentials is S1. This immediate change in the exchange
rate is typical of how the markets react to news, distinct economic and political events that are
observable. The immediate change in the value of the dollar/euro is therefore based on interest
differentials.

As time passes, however, the price impacts of the monetary policy change start working their way
through the economy. As price changes occur over the medium to long term, purchasing power parity
forces drive the market dynamics, and the spot rate moves from S1 toward S2. Although both S1 and S2
were rates determined by the market, they reflected the dominance of different theoretical principles.
As a result, the initial lower value of the dollar of S1 is often explained as an overshooting of the
longer-term equilibrium value of S2.

17. Foreign Currency Speculation. The emerging market crises of 1997–2002 were worsened because
of rampant speculation. Do speculators cause such crisis or do they simply respond to market signals
of weakness? How can a government manage foreign exchange speculation?

“Hot money” is a term used to describe funds held in one currency (country) that will move very
quickly to another currency as soon as it is deemed weak. Such a quick flow will create severe short-
term pressures on the exchange rate, forcing depreciation or a devaluation. This run on the currency
may cause others to also try to exchange their local currency holdings for foreign money, aggravating
the already apparent weakness.

If a currency is fundamentally weak, a speculator such as George Soros may lead a flight from that
currency. He will succeed if he is correct in his assessment of the fundamentals, but if he is in error,
he will lose on the speculation. In the Malaysian situation, Soros correctly assessed the situation and,
by moving first ,was probably instrumental in setting in motion underlying factors that would have
influenced exchange rates in any case—possibly at a later date. In other words, Soros did not cause

© 2016 Pearson Education, Inc.

54 ▪ Eiteman/Stonehill/Moffett | Multinational Business Finance, 14th Edition

the currency crisis in a fundamental sense, but he may well have caused (and advanced) the timing of
what would have occurred eventually in any case.

18. Cross-Rate Consistency in Forecasting. Explain the meaning of “cross-rate consistency” as used by
MNEs. How do MNEs use a check of cross-rate consistency in practice?

International financial managers must often forecast their home currency exchange rates for the set of
countries in which the firm operates, not only to decide whether to hedge or to make an investment,
but also as an integral part of preparing multi-country operating budgets in the home country’s
currency. These are the operating budgets against which the performance of foreign subsidiary
managers will be judged. Checking the reasonableness of the cross rates implicit in individual
forecasts acts as a reality check to the original forecasts.

19. Stabilizing Versus Destabilizing Expectations. Define stabilizing and destabilizing expectations,
and describe how they play a role in the long-term determination of exchange rates.

If market participants have stabilizing expectations, when forces drive the currency’s value below the
long-term fundamental equilibrium path, they will buy the currency driving its value back toward the
fundamental equilibrium path. If market participants have destabilizing expectations and forces drive
the currency’s value away from the fundamental path, participants may not move immediately or in
significant volume to push the currency’s value back toward the fundamental equilibrium path for an
extended period of time (or possibly establish a new long-term fundamental path).

20. Currency Forecasting Services. Many multinational firms use forecasting services regularly. If
forecasting is essentially “foretelling the future,” and that is theoretically impossible, why would
these firms spend money on these services?

If nothing else, a variety of opinions is generally useful when attempting to predict the future. Most
forecasting services also provide added discipline to the forecasting process often missing within
smaller corporate finance units. For example, the need to focus on the likely movement of an
exchange rate within a specific time interval is typically stressed within a forecasting unit while not
within a business unit’s planning horizon. A treasurer might also use a forecasting service because “it
exists.” If the treasurer does not use it, and guesses wrong on an exchange rate, the treasurer could be
criticized for not using available “expert advice.”

© 2016 Pearson Education, Inc.

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