Multinational Business Finance
10-1
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Exchange rate determination is complex.
The following exhibit provides an overview of the many
determinants of exchange rates.
the three major schools of thought (parity conditions,
balance of payments approach, asset market approach).
These are not competing theories but rather complementary
theories.
10-2
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Without the depth and breadth of the various approaches
combined, our ability to capture the complexity of the global
market for currencies is limited.
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In addition to gaining an understanding of the basic theories,
it is equally important to gain a working knowledge of:
 the complexities of international political economy;
 societal and economic infrastructures; and,
 random political, economic, or social events affect the exchange rate
markets.
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10-4
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The theory of purchasing power parity is the
most widely accepted theory of all exchange
rate determination theories:
 PPP is the oldest and most widely followed of the
exchange rate theories.
 Most exchange rate determination theories have
PPP elements embedded within their
frameworks.
 PPP calculations and forecasts are however
plagued with structural differences across
countries.
10-5
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The balance of payments approach is the
second most utilized theoretical approach in
exchange rate determination:
 The basic approach argues that the equilibrium
exchange rate is found when net currency
inflows (inflow) from capital account activities
match up with net currency outflows (inflows)
from current account activities.
 This framework enjoys wide appeal as BOP
transaction data is readily available and widely
reported.
10-6
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The monetary approach states that the
exchange rate is determined by the supply
and demand for national monetary stocks, as
well as the expected future levels and rates of
growth of monetary stocks.
Other financial assets, such as bonds are not
considered relevant for exchange rate
determination, as both domestic and foreign
bonds are viewed as perfect substitutes.
10-7
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The asset market approach argues that
exchange rates are determined by the supply
and demand for a wide variety of financial
assets:
 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 exchange
rates.
10-8
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The forecasting inadequacies of fundamental
theories has led to the growth and popularity
of technical analysis, the belief that the
study of past price behavior provides insights
into future price movements.
The primary assumption is that exchange
rates follows trends.
10-9
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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 (among others):
 Relative real interest rates
 Prospects for economic growth
 Capital market liquidity
 A country’s economic and social infrastructure
 Political safety
 Corporate governance practices
 Contagion (spread of a crisis within a region)
 Speculation
10-10
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Foreign investors are willing to hold securities
and undertake foreign direct investment in
highly developed countries based primarily
on relative real interest rates and the outlook
for economic growth and profitability.
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The asset market approach is also applicable
to emerging markets, however in these cases
a number of additional variables contribute to
exchange rate determination (previous slide).
10-11
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Although the three different schools of thought on exchange rate
determination (parity conditions, balance of payments approach, asset
approach) make understanding exchange rates appear to be
straightforward, that it rarely the case.
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The large and liquid capital and currency markets follow many of the
principles outlined so far relatively well in the medium to long term.
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The smaller and less liquid markets, however, frequently demonstrate
behaviors that seemingly contradict the theory.
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The problem lies not in the theory, but in the relevance of the
assumptions underlying the theory.
10-12
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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.
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The most visible roots of the crisis were the excess capital
inflows into Thailand in 1996 and early 1997.
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As the investment “bubble” expanded, some market
participants questioned the ability of the economy to repay
the rising amount of debt and the Thai bhat came under
attack.
10-13
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The Thai government intervened directly (using up precious
hard currency reserves) and indirectly by raising interest
rates in support of the currency.
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Soon thereafter, the Thai investment markets ground to a
halt and the Thai central bank allowed the bhat to float.
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The bhat fell dramatically and soon other Asian currencies
(Philippine peso, Malaysian ringgit and the Indonesian
rupiah) came under speculative attack.
10-14
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The Asian economic crisis (which was much
more than just a currency collapse) had many
roots besides traditional balance of payments
difficulties:
 Corporate socialism
 Corporate governance
 Banking liquidity and management
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What started as a currency crisis became a
region-wide recession.
10-15
10-16
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In 1991 the Argentine peso had been fixed to
the US dollar at a one-to-one rate of
exchange.
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A currency board structure was implemented
in an effort eliminate the source inflation that
had devastated the nation’s standard of living
in the past.
10-17
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By 2001, after three years of recession, three
important problems with the Argentine
economy became apparent:
 The Argentine Peso was overvalued
 The currency board regime had eliminated
monetary policy alternatives for macroeconomic
policy
 The Argentine government budget deficit – and
deficit spending – was out of control
10-18
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In January 2002, the peso was devalued as a result of
enormous social pressures resulting from deteriorating
economic conditions and substantial runs on banks.
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However, the economic pain continued and the banking
system remained insolvent.
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Social unrest continued as the economic and political
systems within the country collapsed; certain government
actions set the stage for a constitutional crisis.
10-19
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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.
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The single most important element of technical analysis is that future
exchange rates are based on the current exchange rate.
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Exchange rate movements can be subdivided into three periods:
 Day-to-day
 Short-term (several days to several months)
 Long-term
10-21
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The longer the time horizon of the forecast,
the more inaccurate the forecast is likely to
be.
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Forecasting for the long run must depend on
the economic fundamentals of exchange
rate determination.
10-22
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It appears, from decades of theoretical and
empirical studies, that exchange rates do
adhere to the fundamental principles and
theories previously outlined.
Fundamentals do apply in the long term
There is, therefore, something of a
fundamental equilibrium path for a currency’s
value.
10-23
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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 behavior is sometimes referred to as
noise.
Therefore, we might expect deviations from
the long-term path not only to occur, but to
occur with some regularity and relative
longevity.
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How would you actually go about calculating
the statistical accuracy of these forecasts?
Would Vesi have been better off using the
current spot rate as the forecast of the future
spot rate, 90 days out?
Forecasting the future is obviously a daunting
challenge. All things considered, how well do
you think JPMC is doing?
If you were Vesi, what would you conclude
about the relative accuracy of JPMC’s spot
rate forecasts?
10-28
Exhibit 10.2 The Economies and Currencies of Asia, July–
November 1997
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