Foreign Exchange Rate Determination

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Chapter 8
Foreign Exchange Rate Determination

FINA470 Concordia University Summer 2015

Foreign Exchange Rate Determination
Three basic approaches
Parity conditions
Balance of Payments
Asset market

These are not competing theories but are in fact complimentary theories Without the depth and breadth of the various approaches combined, our ability to capture the complexity of the global market for currencies is lost

FINA470

Concordia University Summer 2015

8-2

Exhibit 8.1 The Determinants of Foreign Exchange
Rates

FINA470

Concordia University Summer 2015

8-3

Purchasing Power Parity Approaches
Oldest and most widely followed theory
Embedded within most theories of exchange rate determination
Has significant data challenges in estimation

Versions: Law of One Price, Absolute and Relative PPP
Relative PPP - explains that changes in relative prices between countries drive the change in exchange rates over time

FINA470

Concordia University Summer 2015

8-4

Balance of Payments (Flows) Approach
Equilibrium exchange rate is achieved when current account net inflows (outflow) match financial account outflows (inflow)
BOP transactions are widely captured and reported

Criticism for focusing on flows rather than stocks of money or financial assets
Dismissed by academic community but used by market participants FINA470

Concordia University Summer 2015

8-5

Monetary Approaches
The exchange rate is determined by
The supply and demand for national monetary stocks
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.

FINA470

Concordia University Summer 2015

8-6

Asset Market Approach (Relative Prices of Bonds)
Also called relative price of bonds or portfolio balance approach
Argues that exchange rates are determined by supply and demand for a wide variety of assets
Shifts in supply and demand alter exchange rates
Changes in monetary and fiscal policy alter expectations and thus exchange rates
Theories of currency substitution follow the same basis premises of portfolio rebalance framework

FINA470

Concordia University Summer 2015

8-7

Technical Analysis
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 any market driven price (i.e. exchange rates) follows trends.

FINA470

Concordia University Summer 2015

8-8

The Asset Market Approach to
Forecasting
The asset market approach assumes that whether foreigners are willing to hold claims in monetary form depends on a set 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

FINA470

Concordia University Summer 2015

8-9

Currency Market Intervention
Foreign currency intervention is the active management, manipulation, or intervention in the market’s valuation of a country’s currency. Why Intervene?
– Fight inflation (strong currency)
– Fight slow economic growth (weak currency)

FINA470

Concordia University Summer 2015

8 - 10

Intervention Methods
Determined by magnitude of a country’s economy, magnitude of trading in it’s currency, and the country’s financial market development

Types
Direct Intervention
Indirect Intervention
Capital control

FINA470

Concordia University Summer 2015

8 - 11

Currency Market Intervention
Direct Intervention – Actively buying and selling the domestic currency against foreign currencies
Indirect Intervention – The most obvious and widely used factor is interest rate
Capital Controls - This is the restriction of access to
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