Topic_4_Essentials__1_

ESG UQAM

• Département de finance

• École des sciences de la gestion

• Université du Québec à Montréal

• Course: FIN 5580 - Multinational Finance

• Topic 4: Foreign Exchange Determination

• Professor: Pouya Behmaram

Learning Objectives

• Explore the three major theoretical approaches to exchange rate determination.

• Detail how and why direct and indirect foreign exchange market intervention is conducted by central banks.

• Analyze the primary causes of exchange rate disequilibrium in emerging market currencies.

• Observe how forecasters combine technical analysis with the three major theoretical approaches to forecasting exchange rates.

Overview of Exchange Rate Determination

• Complex Nature: Exchange rate determination is multifaceted.

• Determinants Overview: An overview of the factors influencing exchange rates includes:

  • Parity Conditions Approach

  • Balance of Payments Approach

  • Monetary and Asset Market Approaches

• These theories are not mutually exclusive but rather complementary.

The Determinants of Foreign Exchange Rates

• Key Questions:

  • Is there a well-developed and liquid money and capital market in that currency?

  • Is there a sound and secure banking system in place for currency trading?

• Both financial and banking systems play critical roles in supporting currency valuation.

Theoretical Approaches to Exchange Rate Determination

• Major Theoretical Determinants:

  • Parity Conditions Approach

  • Balance of Payments Approach

  • Monetary and Asset Market Approaches

• Most determinants are affected mutually by changes in the spot rate.

Parity Conditions Approach

• Purchasing Power Parity (PPP):

  • Widely accepted theory indicating that exchange rates adjust to equalize the prices of goods and services across countries.

  • Challenges: PPP calculations face difficulties due to structural differences and data estimation.

• Example Calculation:

  • Given ¥90.00/$ and price changes of 2% in Japan and 1% in the US, forecasting the next spot exchange rate:

    • [ St+1 = St \times \frac{1 + \Delta \text{Japanese prices}}{1 + \Delta \text{US prices}} = ¥90.00/ ext{ extdollar} \times \frac{1.02}{1.01} \approx ¥90.89/ ext{ extdollar} ]

Balance of Payments Approach

• Functionality:

  • Equilibrium exchange rates occur when currency flows align with current and financial account activities.

  • Data used is widely reported, making this approach appealing.

• Criticism:

  • Does not consider stocks of money or financial assets.

Monetary and Asset Market Approaches

• Monetary Approach:

  • Exchange rate determined by supply and demand for national monetary stocks and expected future growth rates.

  • Changes in relative inflation rates impact exchange rates through the PPP effect.

• Asset Market Approach:

  • Focuses on the supply and demand for various financial assets (e.g., bonds).

  • Changes in monetary and fiscal policies influence expected returns and perceived risks, affecting currency valuation.

Currency Market Intervention

• Foreign Currency Intervention:

  • Central banks may manipulate their currency’s market valuation actively.

  • Reasons for Intervention:

    • Combat inflation with a strong currency.

    • Stimulate growth with a weaker currency.

• Methods of Intervention:

  • Direct Intervention:

    • Buying/selling domestic currency to impact its value.

  • Indirect Intervention:

    • Adjusting economic fundamentals to influence currency value.

Case Studies in Currency Crisis

• Japanese Yen Interventions (2010):

  • Bank of Japan aimed to weaken yen through dollar purchases, achieving limited success.

• Asian Crisis (1997):

  • Roots in economic transition from net exporters to importers and capital inflows.

  • Direct and indirect interventions were employed, but ultimately, the baht floated leading to wider regional impacts.

• Argentine Peso Collapse (2002):

  • Resulted from social pressures and economic conditions, prompting a shift to floating rates amidst banking chaos.

Currency Forecasting Dynamics

• Forecasting Periods:

  • Review methodologies for various horizons, recognizing the trade-off between accuracy and time frame.

• Technical Analysis in Forecasting:

  • Focus on past price and volume data to predict future trends, highlighting the need for blending fundamentals with technical insights.

• Short vs Long-Term Dynamics:

  • Short-term forecasts face more noise due to random events, while fundamentals matter more in the long run.

Summary and Conclusions

• Understanding Exchange Rates:

  • Exchange rates often appear disconnected from theoretical principles in the short term but align over longer periods.

• Market Behavior:

  • Currency markets react to ongoing news, but underlying fundamentals eventually assert themselves in long-run valuations.