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PAN African e-Network Project

MFM
International Finance & Forex Management
Semester - 3
Session - 3

Mr. Navneet Saxena


Objective
In this session we will learn about:
Module III: Foreign Exchange Rate
Determination
Theories of Exchange Rate Determination,
Fundamental International Parity Conditions
Purchasing Power and Interest Rate Parity,
Forecasting Exchange Rates - Technical
Forecasting, Time Series Modelling,
Fundamental Forecasting.
Theories of Exchange Rate Determination

Prior to the monetary-approach emphasis


of the 1970s, it was common to emphasize
international trade flows as primary
determinants of exchange rates.
This was due, in part, to the fact that
governments maintained tight restrictions
on international flows of financial capital.
Theories of Exchange Rate Determination

The role of exchange rate changes in eliminating


international trade imbalances suggests that we
should expect countries with current trade
surpluses to have an appreciating currency,
whereas countries with trade deficits should
have depreciating currencies.
Such exchange rate changes would lead to
changes in international relative prices that
would work to eliminate the trade imbalance.
Theories of Exchange Rate Determination

In recent years, it has become clear that


the world does not work in the simple way
just considered.
For instance, with financial liberalization
we have seen that the volume of
international trade in financial assets now
dwarfs trade in goods and services.
Theories of Exchange Rate Determination

Moreover, we have seen some instances


where countries with trade surpluses have
depreciating currencies, whereas
countries with trade deficits have
appreciating currencies.
Economists have responded to such real-
world events by devising several
alternative views of exchange rate
determination.
Theories of Exchange Rate Determination

These theories place a much greater emphasis


on the role of the exchange rate as one of many
prices in the worldwide market for financial
assets.
Modern exchange rate models emphasize
financial-asset markets.
Rather than the traditional view of exchange
rates adjusting to equilibrate international trade
in goods, the exchange rate is viewed as
adjusting to equilibrate international trade in
financial assets.
Theories of Exchange Rate Determination

Because goods prices adjust slowly relative


to financial asset prices and financial assets
are traded continuously each business day,
the shift in emphasis from goods markets to
asset markets has important implications.
Exchange rates will change every day or
even every minute as supplies of and
demands for financial assets of different
nations change.
Theories of Exchange Rate Determination

An implication of the asset approach is


that exchange rates should be much more
variable than goods prices.
This seems to be an empirical fact.
Exchange rate models emphasizing
financial-asset markets typically assume
perfect capital mobility.
Theories of Exchange Rate Determination

In other words, capital flows freely between


nations as there are no significant transactions
costs or capital controls to serve as barriers to
investment.
In such a world, covered interest arbitrage will
ensure covered interest rate parity.
If domestic and foreign bonds are perfect
substitutes, then demanders are indifferent
toward the currency of denomination of the bond
as long as the expected return is the same.
Purchasing Power Parity
By definition the PPP states that using a
unit of a currency, let us say one euro,
which is the purchasing power that can
purchase the same goods worldwide.
The theory is based on the law of one
price, which argues that should a euro
price of a good be multiplied by the
exchange rate ( /US$) then it will result in
an equal price of the good in US dollars.
Purchasing Power Parity
In other words, if we assume that the
exchange rate between the and US $
states at 1/1.2, then goods that cost 10 in
the EU should cost US$ 12 in the United
States.
Otherwise, arbitrage profits will occur.
However, it is finally the market that through
supply and demand will force accordingly the
euro and US dollar prices to the equilibrium
point.
Purchasing Power Parity
Thus, the law of one price will be
reinstated, as well as the purchase power
parity between the euro and US dollar.
Inflation differentials between countries will
also be eliminated in terms of their effect
on the prices of the goods because the
PPP will adjust to equal the ratio of their
price levels.
Purchasing Power Parity
More specifically, as stated in their book
(Lumby S. & Jones C. 1999) the currency
of the country with the higher rate of
inflation will depreciate against the other
countrys currency by approximately the
inflation deferential.
Purchasing Power Parity
In conclusion, it can be argued that the
theory, although it describes in a sufficient
way the determination of the exchange rates,
is not of good value, mainly because of the
following two disadvantages.
Firstly, not all goods are traded internationally
(for example, buildings) and secondly, the
transportation cost should represent a small
amount of the goods worth.
Purchasing Power Parity
PPPs are the rates of currency conversion
that equalize the purchasing power of
different currencies by eliminating the
differences in price levels between
countries. In their simplest form, PPPs are
simply price relatives that show the ratio of
the prices in national currencies of the
same good or service in different
countries.
Purchasing Power Parity
PPPs are also calculated for product
groups and for each of the various levels
of aggregation up to and including GDP.
The calculation is undertaken in three
stages. The first stage is at the product
level, where price relatives are calculated
for individual goods and services. A simple
example would be a litre of Coca-Cola.
Purchasing Power Parity
If it costs 2.3 euros in France and 2.00$ in
the United States then the PPP for Coca-
Cola between France and the USA is
2.3/2.00, or 1.15. This means that for
every dollar spent on a litre of Coca-Cola
in the USA, 1.15 euros would have to be
spent in France to obtain the same
quantity and quality - or, in other words,
the same volume - of Coca-Cola.
Purchasing Power Parity
The second stage is at the product group level, where
the price relatives calculated for the products in the
group are averaged to obtain unweighted PPPs for the
group. Coca-cola is for example included in the
product group Softdrinks and Concentrates. And the
third stage is at the aggregation levels, where the
PPPs for the product groups covered by the
aggregation level are weighted and averaged to obtain
weighted PPPs for the aggregation level up to GDP (in
our example, aggregated levels are Non-alcoholic
beverages, Food).
Purchasing Power Parity
The weights used to aggregate the PPPs
in the third stage are the expenditures on
the product groups as established in the
national accounts.
The major use of PPPs is as a first step in
making inter-country comparisons in real
terms of gross domestic product (GDP)
and its component expenditures.
Purchasing Power Parity
The rate at which the currency of one country
would have to be converted into that of another
country to buy the same amount of goods and
services in each country
Purchasing Power Parity: Which Weights
Matter?
How fast is the global economy growing? Is
China contributing more to global growth than
the United States? Where is the average person
better off?
Purchasing Power Parity
These types of questions are of great
interest to economists and others, and at
first blush it appears reasonable to
assume that each has a clear-cut answer.
But, as with many things in economics, the
reality is different.
To answer the questions, one must
compare the value of the output from
different countries.
Purchasing Power Parity
But each country reports its data in its own
currency. That means that to compare the
data, each countrys statistics must be
converted into a common currency. However,
there are several ways to do that conversion
and each can give a markedly different
answer.
Two different yardsticks
International financial institutions produce a
wide range of regional and global statistics.
Purchasing Power Parity
The IMF, one of these institutions,
publishes many of its statisticssuch as
the growth of real gross domestic product
(GDP), inflation, and current account
balancestwice a year in its World
Economic Outlook (WEO). These statistics
combine, or aggregate, the results from
many countries into an average.
Purchasing Power Parity
The importance, or weight, of an
individual countrys data in the overall
result depends on the size of its economy
relative to the others being compared. To
derive these weights, one converts the
GDP of a country in terms of its national
currency into a common currency (in
practice, the U.S. dollar).
Purchasing Power Parity
One of the two main methods of conversion
uses market exchange ratesthe rate prevailing
in the foreign exchange market (using either the
rate at the end of the period or an average over
the period). The other approach uses the
purchasing power parity (PPP) exchange rate
the rate at which the currency of one country
would have to be converted into that of another
country to buy the same amount of goods and
services in each country.
Purchasing Power Parity
To understand PPP, lets take a commonly
used example, the price of a hamburger. If a
hamburger is selling in London for 2 and in
New York for $4, this would imply a PPP
exchange rate of 1 pound to 2 U.S. dollars.
This PPP exchange rate may well be different
from that prevailing in financial markets (so
that the actual dollar cost of a hamburger in
London may be either more or less than the
$4 it sells for in New York).
Purchasing Power Parity
This type of cross-country comparison is the
basis for the well-known Big Mac index,
which is published by the Economist
magazine and calculates PPP exchange
rates based on the McDonalds sandwich that
sells in nearly identical form in many
countries around the world.
Of course, any meaningful comparison of
prices across countries must consider a wide
range of goods and services.
Purchasing Power Parity
This is not an easy task, because of the
amount of data that must be collected and
the complexities in the comparison process.
To facilitate price comparisons across
countries, the International Comparisons
Program (ICP) was established by the United
Nations and the University of Pennsylvania in
1968. PPPs generated by the ICP are based
on a global survey of prices.
Purchasing Power Parity
For the 200306 round, each of the
participating countries (about 147)
provided national average prices for 1,000
closely specified products.
PPP versus market rates
So which method is better? The
appropriate way to aggregate economic
data across countries depends on the
issue being considered.
Interest Rate Parity
Interest Rate Parity (IPR) theory is used to
analyze the relationship between at the spot rate
and a corresponding forward (future) rate of
currencies.
The IPR theory states interest rate differentials
between two different currencies will be reflected
in the premium or discount for the forward
exchange rate on the foreign currency if there is
no arbitrage - the activity of buying shares or
currency in one financial market and selling it at a
profit in another.
Interest Rate Parity
The theory further states size of the forward
premium or discount on a foreign currency
should be equal to the interest rate
differentials between the countries in
comparison.
1. Covered Interest Rate Parity (CIRP)
Covered Interest Rate theory states that
exchange rate forward premiums (discounts)
offset interest rate differentials between two
sovereigns.
Interest Rate Parity
In another words, covered interest rate theory
holds that interest rate differentials between
two countries are offset by the spot/forward
currency premiums as otherwise investors
could earn a pure arbitrage profit.
Covered Interest Rate Examples
Assume Google Inc., the U.S. based multi-
national company, needs to pay it's European
employees in Euro in a month's time.
Interest Rate Parity
Google Inc. can achieve this in several
ways viz:
Buy Euro forward 30 days to lock in the
exchange rate. Then Google can invest in
dollars for 30 days until it must convert
dollars to Euro in a month. This is called
covering because now Google Inc. has no
exchange rate fluctuation risk.
Interest Rate Parity
Convert dollars to Euro today at spot
exchange rate. Invest Euro in a European
bond (in Euro) for 30 days (equivalently
loan out Euro for 30 days) then pay it's
obligation in Euro at the end of the month.
Under this model Google Inc. is sure of the
interest rate that it will earn, so it may
convert fewer dollars to Euro today as it's
Euro will grow via interest earned.
Interest Rate Parity
This is also called covering because by
converting dollars to Euro at the spot, the
risk of exchange rate fluctuation is
eliminated.
2. Uncovered Interest Rate Parity (UIP)
Uncovered Interest Rate theory states that
expected appreciation (depreciation) of a
currency is offset by lower (higher)
interest.
Interest Rate Parity
Google Inc. can also invest the money in
dollars today and change it for Euro at the
end of the month.
This method is uncovered because the
exchange rate risks persist in this
transaction.
Covered Interest Rate Vs. Uncovered
Interest Rate
Interest Rate Parity
Recent empirical research has identified
that uncovered interest rate parity does not
hold, although violations are not as large as
previously thought and seems to be
currency rather than time horizon
dependent.
In contrast, covered interest rate parity is
well established in recent decades amongst
the OECD economies for short-term
instruments.
Interest Rate Parity
Any apparent deviations are credited to
transaction costs.
Implications of Interest Rate Parity Theory
If IRP theory holds then arbitrage in not
possible. No matter whether an investor
invests in domestic country or foreign
country, the rate of return will be the same as
if an investor invested in the home country
when measured in domestic currency.
Interest Rate Parity
If domestic interest rates are less than foreign
interest rates, foreign currency must trade at
a forward discount to offset any benefit of
higher interest rates in foreign country to
prevent arbitrage.
If foreign currency does not trade at a forward
discount or if the forward discount is not large
enough to offset the interest rate advantage
of foreign country, arbitrage opportunity
exists for domestic investors.
Interest Rate Parity
So domestic investors can benefit by
investing in the foreign market.
If domestic interest rates are more than
foreign interest rates, foreign currency
must trade at a forward premium to offset
any benefit of higher interest rates in
domestic country to prevent arbitrage.
Interest Rate Parity
If foreign currency does not trade at a
forward premium or if the forward premium
is not large enough to offset the interest
rate advantage of domestic country,
arbitrage opportunity exists for foreign
investors.
So foreign investors can benefit by
investing in the domestic market.
Interest Rate Parity
Limitations of Interest Rate Parity Model
In recent years the interest rate parity
model has shown little proof of working.
In many cases, countries with higher
interest rates often experience it's
currency appreciate due to higher
demands and higher yields and has
nothing to do with risk-less arbitrage.
Interest Rate Parity
Another difference between the Monetary
Approach to Balance of Payment (MBOP)
and the IRP is how they define the
expected exchange rate. In the MBOP, the
expected exchange rate is included in the
parity equation. The expected exchange
rate reflects investors expectations
regarding the exchange rate some time
from now.
Interest Rate Parity
In fact, investors adjust their exchange
rate expectations upward or downward.
However, the MBOP does not explicitly
provide any tools that can quantify the
expected exchange rate.
The IRP quantifies the expected exchange
rate using forward contracts. Forward
contracts are an example of foreign
exchange derivatives.
Interest Rate Parity
You can think of foreign exchange
derivatives as financial contracts where you
lock in a specific exchange rate today for a
future transaction in currencies (buying or
selling of currencies).
A forward contract is an example of a foreign
exchange derivative. It allows you to trade
one currency for another at some date in the
future at an exchange rate specified today.
Interest Rate Parity
Typically, you get a forward contract from
a bank that is engaged in foreign
exchange transactions.
A forward contract includes the forward
rate (the exchange rate on the forward
contract), the amount of currency to be
bought or sold, and the transaction date.
Interest Rate Parity
Forward contracts are binding, in the
sense that there is an obligation to buy or
sell currency at the agreed price for the
agreed quantity on the agreed transaction
day.
The forward rate may be a good
approximation of the expected exchange
rate in the bracket of the parity equation in
the MBOP.
Interest Rate Parity
You might expect that a bank considers the
current and expected values of the relevant
variables for the exchange rate in both
countries and quote a forward rate to you.
Difference between MBOP and IRP
First, when the MBOP talks about the
interest rate differential, it means the
difference in two countries real interest
rates.
Interest Rate Parity
The IRP is also interested in the difference
between interest rates as a predictor for
changes in the exchange rate, but the IRP thinks
in terms of nominal interest rates.
Second, whereas the MBOP uses the concept of
an expected exchange rate, it doesnt specify
how you can measure it. The IRP, on the other
hand, uses the forward rate as indicated on a
forward contract to get a numerical estimate for
the expected change in the exchange rate.
Forecasting Exchange Rates
There are numerous methods of forecasting
exchange rates, likely because none of them
have been shown to be superior to any other.
This speaks to the difficulty of generating a
quality forecast.
Purchasing Power Parity (PPP)
The purchasing power parity (PPP) is perhaps
the most popular method due to its
indoctrination in most economic textbooks.
Forecasting Exchange Rates
The PPP forecasting approach is based off of
the theoretical Law of One Price, which
states that identical goods in different
countries should have identical prices.
For example, this law argues that a pencil in
Canada should be the same price as a pencil
in the U.S. after taking into account the
exchange rate and excluding transaction and
shipping costs.
Forecasting Exchange Rates
Relative Economic Strength Approach
As the name may suggest, the relative
economic strength approach looks at the
strength of economic growth in different
countries in order to forecast the direction of
exchange rates. The rationale behind this
approach is based on the idea that a strong
economic environment and potentially high
growth is more likely to attract investments
from foreign investors.
Forecasting Exchange Rates
And, in order to purchase investments in
the desired country, an investor would
have to purchase the country's currency -
creating increased demand that should
cause the currency to appreciate.
This approach doesn't just look at the
relative economic strength between
countries. It takes a more general view
and looks at all investment flows.
Forecasting Exchange Rates
For instance, another factor that can draw
investors to a certain country is interest rates.
High interest rates will attract investors looking
for the highest yield on their investments,
causing demand for the currency to increase,
which again would result in an appreciation of
the currency. Conversely, low interest rates can
also sometimes induce investors to avoid
investing in a particular country or even borrow
that country's currency at low interest rates to
fund other investments.
Forecasting Exchange Rates
Many investors did this with the Japanese
yen when the interest rates in Japan were
at extreme lows. This strategy is
commonly known as the carry-trade.
Unlike the PPP approach, the relative
economic strength approach doesn't
forecast what the exchange rate should
be.
Forecasting Exchange Rates
Rather, this approach gives the investor a
general sense of whether a currency is
going to appreciate or depreciate and an
overall feel for the strength of the
movement. This approach is typically used
in combination with other forecasting
methods to develop a more complete
forecast.
Forecasting Exchange Rates
Econometric Models
Another common method used to forecast
exchange rates involves gathering factors that
you believe affect the movement of a certain
currency and creating a model that relates these
factors to the exchange rate.
The factors used in econometric models are
normally based on economic theory, but any
variable can be added if it is believed to
significantly influence the exchange rate.
Forecasting Exchange Rates
As an example, suppose that a forecaster for a
Canadian company has been tasked with
forecasting the USD/CAD exchange rate over the
next year. He believes an econometric model would
be a good method to use and has researched
factors he thinks affect the exchange rate. From his
research and analysis, he concludes the factors that
are most influential are: the interest rate differential
between the U.S. and Canada (INT), the difference
in GDP growth rates (GDP), and income growth rate
(IGR) differences between the two countries.
Forecasting Exchange Rates
The econometric model he comes up with is shown
as:
USD/CAD (1-year) = z + a(INT) + b(GDP) + c(IGR)
We won't go into the details of how the model is
constructed, but after the model is made, the
variables INT, GDP and IGR can be plugged into
the model to generate a forecast. The coefficients a,
b and c will determine how much a certain factor
affects the exchange rate and direction of the effect
(whether it is positive or negative).
Technical Forecasting
International transactions are usually
settled in the near future. Exchange rate
forecasts are necessary to evaluate the
foreign denominated cash flows involved
in international transactions. Thus,
exchange rate forecasting is very
important to evaluate the benefits and
risks attached to the international business
environment.
Technical Forecasting
A forecast represents an expectation about a
future value or values of a variable. The
expectation is constructed using an
information set selected by the forecaster.
Based on the information set used by the
forecaster, there are two pure approaches to
forecasting foreign exchange rates:
(1) The fundamental approach.
(2) The technical approach.
Technical Forecasting
Technical analysis in exchange rates is a
method which is used to predict the future
trends of exchange rates in forex market
by analyzing the past market data, mainly
the data related to volume and price.
Technical analysis in forex exchange rates
forecasting focuses on recognizing the
rate patterns and trends and tries to
explore those trends.
Technical Forecasting
There are various tools used by the
technicians, however, the main tools is the
study of price charts.
In exchange rate forecasting with technical
analysis, the experts especially look for
repeated patterns like double top reversal
patterns, candlesticks, head and shoulders
patterns or study indicators like moving
averages.
Technical Forecasting
The indicators, which are mathematical
transformations of historical market data
relating to volume and price, are used
extensively for technical analysis in
exchange rates.
The investors in forex market consider
technical analysis for exchange rate
forecasting as one of the key tools.
Technical Forecasting
As we know that technical analysis in
exchange rates forecasting gives us a clear
picture of prices movement in future by taking
into account the historical market prices
analysis and it is made up of mathematical
equations along with other technical applied
towards market prices. One should have a
through knowledge of forex technical analysis
techniques to get fruitful results.
Technical Forecasting
With technical analysis in forex exchange
rates, one should always remember that
theoretical knowledge added to the thoughtful
strategy gives the key to good results and
positive trading. You shouldn't ever use the
methods you understand not clearly. There is
always a choice from a number of methods
offered, so you can use the one you are good
at and invest adequately for successful Forex
trading.
Technical Forecasting
The forex currency market is essentially
trend-following over a short term period.
A large majority comprises of speculative
market participants and this is the reason
why there are currency transactions
happening which have no underlying
investment transaction behind them.
Technical Forecasting
The forex trading market participants have
to trade off something whether or not there
has been any change in macroeconomic
fundamentals.
The traditional forecasting methods are
not that efficient to predict short term
market moves; therefore some other
analytical method required which can help
in getting better results.
Technical Forecasting
The patterns created by supply and demand in
exchange rate create price patterns, which can
be used for technical analysis in exchange
rates.
Technical analysis is used by the investors
alone or with fundamental analysis exclusively.
There are various methods along with
technical analysis which can be used in
forecasting, but thing is that they all rely on
price movements of the past.
Time Series Modelling
Exchange rate is the currency rate of one
country expressed in terms of the currency
of another country. In the modern world,
exchange rates of the most successful
countries are tend to be floating. This
system is set by the foreign exchange
market over supply and demand for that
particular currency in relation to the other
currencies.
Time Series Modelling
In addition, the exchange rate is guided by
significant impact of the activities of central
banks and other financial institutions.
It seem to be very difficult to analyze how
the foreign exchange rate changes, and
probably even harder to forecast them.
There are lot of works done on time series
based prediction modelling of foreign
currency rates in literature.
Time Series Modelling
Many authors created and tested the
Autoregressive Integrated Moving Average
(ARIMA) model to forecast exchange
rates. Monthly or daily exchange rates
were used as the variable output in these
reports. These studies outlined that the
ARIMA model is comparatively accurate
model to forecast the exchange rate.
Time Series Modelling
Akincilar et al. studied the exchange rate
forecasting of US dollar, euro and Great
Britain pound with respect to the Turkish lira.
Several methods were performed for
forecasting and then compared with the
ARIMA model. The performance of the
models was estimated via mean absolute
percentage error (MAPE), root mean square
errors (RMSE) and mean square error
(MAE).
Time Series Modelling
Weisang et al. further developed a
detailed ARIMA modelling in the form of a
case study using macroeconomic
indicators to model the USD/EUR
exchange rate.
They developed a linear relationship for
the monthly USD/EUR exchange rate over
the period from January 1994 to October
2007.
Time Series Modelling
Besides this, Box-Jenkins approach is
applied successfully in many areas such as
tourism demand, energy and many others.
Box and Jenkins ARIMA
technique has been extensively used as a
standard for time series forecasting and for
evaluation of the new modelling approaches
in the last twenty five years, and probably it
dominates the time series forecasting.
Time Series Modelling
Box-Jenkins paid special attention to the
selecting the model and its evaluation. The
methodology for constructing ARIMA
model for the investigated time series
includes the following main steps:
1. Identification of test patterns;
2. Estimation of the model parameters and
identifying the adequacy of the model;
Time Series Modelling
3. The use of models to predict.
Forecasting exchange rate appears to be
a very attracting topic in international
finance.
Time series modeling is a dynamic
research area which has attracted
attentions of researchers community over
last few decades.
Time Series Modelling
The main aim of time series modeling is to
carefully collect and rigorously study the
past observations of a time series to
develop an appropriate model which
describes the inherent structure of the
series.
This model is then used to generate
future values for the series, i.e. to make
forecasts.
Time Series Modelling
Time series forecasting thus can be
termed as the act of predicting the future
by understanding the past. Due to the
indispensable importance of time series
forecasting in numerous practical fields
such as business, economics, finance,
science and engineering, etc., proper care
should be taken to fit an adequate model
to the underlying time series.
Fundamental Forecasting
Fundamental analysis is the study of
economic factors that influence foreign
exchange rates in the hope of trying to
forecast future rates. Fundamental
analysis in forex attempts to predict
currency moves by studying interest rates,
government policies, business cycles, and
economic growth in the 2 countries where
the currencies are being compared.
Fundamental Forecasting
Both countries must be compared
because the foreign exchange rate is
determined by the relative value of the
currencies in the 2 countries, so if
economic factors increase the strength of
the currency in 1 country, that will have the
same effect on the exchange rate if
economic factors in the other country
weakens its currency.
Fundamental Forecasting
So any change in exchange rates can result
either because a currency strengthened or
the other weakened, or both, and vice versa.
In contrast, technical analysis involves the
study of volume and price levels, and chart
patterns of currencies to forecast future
currency moves, which is predicated on the
assumption that certain patterns in the charts
can forecast, more often than not, exchange
rates.
Fundamental Forecasting
It is fundamental analysis, however, that
examines the economic factors that
ultimately determines currency rates, since
it is based on cause and effect. Since any
forex transaction involves the exchange of 1
currency for another, fundamental analysis
must, by necessity, take into account the
supply and demand of each currency with
respect to the other, which determines the
exchange rate.
Fundamental Forecasting
Hence, proponents of fundamental analysis
try to ascertain supply and demand by
studying various economic indicators and
other economic data which will affect the
supply and demand of each currency with
respect to the other.
The most important economic factors of the 2
currencies being compared are inflation
rates, interest rates, and investment
opportunities.
Fundamental Forecasting
The 2 factors that governments have the
most influence over are inflation and
interest rates.
Inflation is generally caused when the
government increases the money supply
faster than the economy is growing. If the
inflation rate is higher in one country then
in another, then the relative value of its
currency will decline.
Fundamental Forecasting
Indeed, some countries print so much money
that the currency becomes worthless as
money. For instance, people in Zimbabwe
would sometimes use Zim dollars as toilet
paper. Because money has such an
important function in all societies, people will
often find substitutes when the domestic
currency becomes worthless even using
the currency of another country, in what is
known as dollarization.
Fundamental Forecasting
While inflation lowers the value of
currency, higher interest rates increase it,
since higher interest rates draws capital
from around the world as money seeks a
higher rate of return, thereby, increasing
the demand for the currency as foreigners
convert their domestic currency into the
investment currency.
Fundamental Forecasting
One such example is the so-called carry
trade, which involves borrowing currency
from a country with low interest rates to
invest it in a country with higher rates,
such as when investors borrow Japanese
yen at low interest rates to invest in New
Zealand and Australia, which usually have
the highest interest rates.
Fundamental Forecasting
Investment opportunities have the same
effect as higher interest rates; indeed,
higher interest rates are simply another
form of investment opportunity. However,
other than interest rates, governments do
not have as much control over investment
opportunities, although they exert influence
by their stewardship of their economies.
Another major factor is the size of the
economies.
Fundamental Forecasting
If an economy is underdeveloped, compared
with the rest of the world, then it will have a
much greater potential for growth relative to a
developed economy, since foreign companies
will seek to sell their goods and services in a
market that is far from being saturated. Such is
the case today, as companies around the world
strive to have a presence in China and India,
where the potential for sales growth is much
greater than in, say, the United States or
Europe.
Fundamental Forecasting
Investment risks have the opposite effect
of higher interest rates and greater
investment opportunities, in that higher
investment risks will lower the demand for
the investments. In foreign exchange, after
inflation and interest rate risk, the main
investment risks in foreign countries,
especially smaller, volatile countries, is
political risk.
Fundamental Forecasting
Political risk often takes the form of
market volatility, when it becomes difficult
to forecast interest rates or other
economic factors that may affect
businesses. High taxes may reduce
investment returns and the country may
institute capital controls, restricting the
flow of capital either into the country or out
of the country or both.
Fundamental Forecasting
Any type of capital control will reduce the demand
for the currency, since investors usually don't like
to lose control of their capital.
Since inflation, interest rates, and returns on
investments are the most important factors in
determining exchange rates, foreign exchange
traders frequently scan publications mostly
issued by central banks, since they usually
determine interest rates and control the supply of
money for any indication on how these factors
will change.
Fundamental Forecasting
Forex traders generally have expectations
about what a country will do, so any
surprises from what was expected may
change exchange rates dramatically.
Hence, the key to forecasting exchange
rate moves using fundamental analysis
requires that the trader know the publication
schedule of major reports for each relevant
country and understand their significance.
Fundamental Forecasting
Fundamental analysis - Consists of
reviewing the economic and political
reasons behind currency moves. Often
involves interpreting the micro and macro
economic indicators for the currency's
nation in order to determine the relative
value of the currency versus another
currency. Fundamental analysis can be
better for forecasting longer term exchange
rate moves.
Fundamental Forecasting
Fundamental analysis in the forex market
typically involves taking into account basic
economic and political factors for one
country relative to another. These factors
might include the following:
Measures of overall economic strength like
growth and employment rates
Interest rates and investment yields
Trade and current account balances
Fundamental Forecasting
Political stability
Fundamental forecasts for exchange rates
are typically most useful for longer term
time frames and not so much for short
term trading. Nevertheless, some
fundamental trading strategies have been
developed that operate during the volatile
period that often immediately follows
important economic data releases.
Fundamental Forecasting
Some traders prefer technical analysis and
take issue with fundamental analysis on the
basis that:
Its information is largely already priced into
the market
It is time consuming and complicated to
perform
It often requires an economics background
It does not give objective trading signals
Fundamental Forecasting
Economic indicators are statistics,
published periodically, that measure
various factors of the economy, many of
which affect, or are affected, by the supply
and demand of the domestic currency.
Moreover, central banks rely on economic
indicators to formulate monetary policy,
which can have a significant effect on
foreign exchange rates.
Recap
In this session we learnt about:
Module III: Foreign Exchange Rate
Determination
Theories of Exchange Rate Determination,
Fundamental International Parity Conditions
Purchasing Power and Interest Rate Parity,
Forecasting Exchange Rates - Technical
Forecasting, Time Series Modelling,
Fundamental Forecasting.
Please forward your query

To: nsaxena1@amity.edu