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
International
Parity Conditions (Ch 7)
Exchange
Rates
1.
2.
3.
4.

Relative inflation rates (RPPP)

Relative interest rates (international Fisher effect)
Forward exchange rates
Interest rate parity (IRP)

Technical Analysis

Monetary Approach

Spot
Exchange
Rate

Asset Market Approach (Ch 10)

Balance of Payments (Ch 4)

1.
2.
3.
4.
5.
6.

1.
2.
3.
4.
5.

Relative real interest rates

Prospects for economic growth
Supply & demand for financial assets
Outlook for political stability
Speculation & market liquidity
Contagion & corporate governance

Current account balances

Portfolio investment
Foreign direct investment
Official monetary reserves
Exchange rate regimes

Mostdeterminantsoftheexchangerate,e.g.,thebalanceofBOP,theinflationrates,
thenominalandrealinterestrates,andtheeconomicprospects,arealsointurn
affectedbychangesintheexchangerate
Inotherwords,theyarenotonlylinkedbutmutuallydetermined
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
The Monetary Approach states that the supply and demand for
Theoretical
Thread
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
Interest rate domestic currency depreciation
Theoretical
Thread
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
The monetary approach
omits a number of factors:
Thread

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
The Asset Market Approach
Threadargues 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
More specifically, ifThread
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
Technical analysis Thread
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 crossborder 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
inThe
asset market approach
is also applicable to
Emerging
Markets

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 ShortTerm Noise from Long-Term Trends

Political or social events or weak
infrastructure (e.g., the banking system)
Foreign currency per
may drive the exchange
unit of domestic currency rate from the long-term path significantly
Fundamental
Equilibrium
Path

Short-term forces may induce

noiseshorttermvolatility
aroundthelongtermpath
Time

Thelongtermequilibriumpathisnotalwaysapparentintheshortterm
(althoughrelativelywelldefinedinretrospect)
Somestudiesalsopointoutthattheexchangerateitselfmaydeviatein
somethingofacycleorwaveaboutthelongtermpath

10-43

Exhibit 10.7 Exchange Rate

Forecasting in Practice

financial condition

10-44

JPMorgan Chases Forecasting

Accuracy (US$/)

TheabovefigureshowstheforecastofJPMorganChaseforthe90dayUS$/
exchangerateintothefuture
InFebruaryof2004,itforecastedtheexchangeratetomovefrom$1.27/to
$1.32/,butinfacttherealizedexchangerateafter90daysis$1.19/,
whichillustratesthedifficultytoforecastthemovementoftheexchangerate

10-45

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 S0 to S1 (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
Spot Exchange
Rate ($/ )
S1

Sincetheexchangerateisexpressedas
US$pricepereuro,S1>S0(S2>S0)
representsthedepreciationoftheUS
dollarsagainsttheeuros

Overshooting
S2
S0

t1

t2

Time

ThedifferencebetweenS1andS2reflectsthedominanceofdifferent
theoreticalprinciplesatdifferentpointsintime(firstistheassetmarket
approachandsecondisthePPPtheory)
Asaresult,theinitialhighervalueofS1isoftenexplainedasanovershooting
ofthelongertermequilibriumvalueofS2
10-47