Foreign Exchange
Determination
Forecasting exchange rates
July 17, 2016
Foreign Exchange Determination
1
Forecasting
(fundamental analysis)
 fundamental analysis
 Theoretical analysis
 Purchasing power parity
 balance of payments
 Cash flow analysis
 monetary & fiscal policies
 Stock analysis
 regulatory policies
 Trade policies
 political risk
July 17, 2016
Foreign Exchange Determination
2
Theoretical analysis
 Purchasing power parity
 Assuming efficient markets
 Real world prices converge
 Measurement problems
 Market baskets used to measure inflation
are not consistent
 Fisher effect
 Interest rate parity
July 17, 2016
Foreign Exchange Determination
3
Parity conditions
Purchasing Power Parity
e T

e0
 1  i cd

 1  i usd
Fisher effect
International Fisher effect
e T
e0
Interest rate parity
fT
e0
Unbiased predictor
July 17, 2016
fT
Foreign Exchange Determination
*
 1   cd

*
1



usd



T




T
*
 1   cd

*
1   usd

 1  i cd

1  i usd



T



T

 1  i cd

1  i usd

e T
4



T
Parity conditions
 For parity to hold
 efficient market conditions needed
 Thick markets
 many buyers, many sellers
 Perfect information
 Low or no market frictions
 Transactions costs
 Taxes, tariffs
 May be most useful pointing to the
existence of frictions in the market
July 17, 2016
Foreign Exchange Determination
5
Balance of payments
 Cash flow analysis
 Current acct, capital acct, financial acct,
reserve acct
 Relative demands and supplies of dollars
in the exchange markets
 Function of real cash flows to pay for
 Trade in goods, services, transfers
 FDI, investment in real assets
 Portfolio investment, investment in financial
assets
July 17, 2016
Foreign Exchange Determination
6
Monetary
 Changes in supply and demand for
money
 BOP tracks the foreign exchange as a
medium of exchange (flow)
 Store of wealth (stock)
 Demand for dollars to hold
 Moderates BOP influences
 China holding dollar assets
 Other currencies are substitutes
 Moving from dollar reserves to euro reserves
July 17, 2016
Foreign Exchange Determination
7
Central Bank affects on liquidity
 cash & currency
 directly supplied by CB
 checking accounts & debit cards
 money multiplier determined
 CB directly affects the multiplier
 reserve requirements
 capital requirements
 credit cards
 availability of credit indirectly affected by CB
July 17, 2016
Foreign Exchange Determination
8
Factors affecting money &
exchange rates
 economic growth
 economic growth increases demand for base
 inflation
 CB controls the supply of base money
 interest rates
 CB controls the bank rate directly
 CB influences term structure of interest rates
indirectly
 political risk
July 17, 2016
Foreign Exchange Determination
9
Economic Growth
 Growth increases the demand for money

demand for money curve shifts up
 Assume CB keeps money supply constant
 no change in the vertical supply curve
 the value of money increases
 prices and value of money inversely related
 domestically - deflation
 internationally - exchange rate appreciation
July 17, 2016
Foreign Exchange Determination
10
Money Supply
 Central Bank increases supply of money
 supply curve shifts out
 Assuming no change in demand for money
 the demand for money curve remains stationary
 the value of money decreases
 prices and value of money inversely related
 domestically - inflation
 internationally - exchange rate depreciation
July 17, 2016
Foreign Exchange Determination
11
Asset market
 Bonds, stocks, currencies are close
substitutes
 Changes in demand for financial assets
(other than money)
 Portfolio diversification
 South American investors
 Saudia Arabian investors
 Capital flight
 Seeking efficient markets
 Properly priced financial assets
July 17, 2016
Foreign Exchange Determination
12
Term Structure of
Interest Rates
iT
New term structure of interest rates after
CB increases bank rate
Term to maturity
July 17, 2016
Foreign Exchange Determination
13
Shift in Term Structure of
Interest Rates
 Central bank changes the bank rate
 only rate directly controlled by CB
 least risky rate in the economy
 no default risk
 little interest rate risk - overnight funds rate
 other rates will ratchet up relative to risk
 default - ability to pay
 interest rate risk - relative to term to maturity
July 17, 2016
Foreign Exchange Determination
14
Jump Shift in Term Structure
iT
Jump in term structure after a large change
in political risk
Term to maturity
July 17, 2016
Foreign Exchange Determination
15
Jump Shift in Term Structure
 Small change in power structure
 new rules
 some increase in uncertainty about future
 small discrete change in market risk premium
 Large change in power structure
 systemic change in the economy
 large increase in uncertainty about future
 large discrete change in market risk premium
July 17, 2016
Foreign Exchange Determination
16
Political risk (anticipated)
 Fiscal policies
 taxes, expenditures
 deficit and debt policies
 Monetary policies
 relative inflation, interest rates
 exchange rate (foreign reserves, intervention
 Regulatory policies
 trade restrictions
 capital controls
July 17, 2016
Foreign Exchange Determination
17
Political risk (unanticipated)
 Political risk
 probability of change in government
 probability of change in direction
 external threats
 crime
 war
 Differences between markets
 official markets
 unofficial markets (grey & black markets)
July 17, 2016
Foreign Exchange Determination
18
Technical Analysis
 technical analysis
 Time series analysis
 trends
 correlation
July 17, 2016
Foreign Exchange Determination
19
Political Risk
 party in power makes the rules
 distribution of income and wealth
 tax law
 transfers
 regulatory environment
 increase or decrease frims’ costs of doing
business
 change of party in power
 change in the rules
 for example PQ in power in Québec
July 17, 2016
Foreign Exchange Determination
20
Capital Asset Pricing System
ii  irf  i ( i M  irf )
iM
the market rate increases as the
market becomes more risky
iM - irf the market risk premium also increases
I
July 17, 2016
measure of risk increases with
market volatility
Foreign Exchange Determination
21
Unsterilized Intervention
 gold
 silver
 cd denominated tbills
 foreign currency
denominated t-bills
 cash
 currency
 chartered bank
reserves held at
the Bank of
Canada
Bof C buys US dollars
as an asset
Canadian dollar
liability increases
July 17, 2016
Foreign Exchange Determination
22
Domestic Affects of an
Unsterilzed Intervention
 Base money increases by amount of
purchase
 pressure exerted on prices to
increase
 inflation in the economy
 Canadian goods cost more in cd
July 17, 2016
Foreign Exchange Determination
23
Foreign Affects of an
Unsterlized Intervention
 short run
 exchange rate is not allowed to adjust
 long run
 higher Canadian inflation
 US goods cost relatively less to Canadians
 Canadian goods cost relatively more to US
consumers
 exchange rate remains relatively
constant
July 17, 2016
Foreign Exchange Determination
24
Sterlized Intervention
 gold
 silver
 cd denominated tbills
 foreign currency
denominated t-bills
Bof C buys US
dollars as an asset
B of C sells equal
value in other assets
July 17, 2016
 cash
 currency
 chartered bank
reserves held at
the Bank of
Canada
No increase in
B of C liabilities
Foreign Exchange Determination
25
Domestic Affects of an
Sterilzed Intervention
 Base money remains constant
 prices remain constant
July 17, 2016
Foreign Exchange Determination
26
Foreign Affects of an
Sterlized Intervention
 short run
 exchange rate is not allowed to adjust
 long run
 pressure remains on exchange rate to
depreciate
 BOT deficit remains
 eventually the cd price of the usd will
increase
July 17, 2016
Foreign Exchange Determination
27
BOT (Current Account) Deficit
 currency depreciation
 higher prices for imports
 lower prices for exports
 protectionism
 tariffs, quotas, import restrictions
 capital controls
 restrict foreign ownership
 exchange market intervention
July 17, 2016
Foreign Exchange Determination
28
Covered Interest Arbitrage








Borrow 100,000 cd @ 6.75%
Buy 66,339.39 usd spot at 1.5074
Lend 66,339.39 for one year @ 7.75%
Buy 107,585.59 cd forward @ 1.5051
collect loan of 71,480.69 usd
take delivery of forward contract
pay off loan of 106,750 cd
riskless return of 835.59 cd
July 17, 2016
Foreign Exchange Determination
29