Description
The objective of this presentation about the exchange rate systems used by various governments, explain how governments can use direct and indirect intervention to influence exchange rates, to explain how government intervention in the foreign exchange market can affect economic conditions.
Chapter 6 - Government Influence
On Exchange Rates
Chapter Objectives
? To describe the exchange rate systems used by
various governments
? To explain how governments can use direct and
indirect intervention to influence exchange rates
? To explain how government intervention in the
foreign exchange market can affect economic
conditions.
2-3
Evolution of the
International Monetary System
? Bimetallism: Before 1875
? Classical Gold Standard: 1875-1914
? Interwar Period: 1915-1944
? Bretton Woods System: 1945-1972
? The Flexible Exchange Rate Regime: 1973-Present
2-4
Bretton Woods System:
1945-1972
? Named for a 1944 meeting of 44 nations at Bretton Woods,
New Hampshire.
? The purpose was to design a postwar international
monetary system.
? The goal was exchange rate stability without the gold
standard.
? The result was the creation of the IMF and the World Bank.
2-5
Bretton Woods System:
1945-1972
? Under the Bretton Woods system, the U.S. dollar was
pegged to gold at $35 per ounce and other currencies
were pegged to the U.S. dollar.
? Each country was responsible for maintaining its
exchange rate within ±1% of the adopted par value by
buying or selling foreign reserves as necessary.
? The Bretton Woods system was a dollar-based gold
exchange standard.
Exchange Rate Systems
? Exchange rate systems can be classified
according to the degree to which the rates are
controlled by the government.
? Exchange rate systems normally fall into one of
the following categories:
? fixed
? freely floating
? managed float
? pegged
? In a fixed exchange rate system, exchange rates are
either held constant or allowed to fluctuate only
within very narrow bands.
? The Bretton Woods era (1944-1971) fixed each
currency’s value in terms of gold.
? The 1971 Smithsonian Agreement which followed
merely adjusted the exchange rates and expanded
the fluctuation boundaries. The system was still
fixed.
Fixed Exchange Rate System
? Pros: Work becomes easier for the MNCs.
? Cons: Governments may revalue their
currencies. In fact, the dollar was devalued more
than once after the U.S. experienced balance of
trade deficits.
? Cons: Each country may become more
vulnerable to the economic conditions in other
countries.
Fixed Exchange Rate System
? Assume there are only 2 countries in world (US, UK) and have a fixed
exchange rate
? US inflation increase, UK inflation const. US imports increase, US exports
decrease
? US production decreases, unemployment increases
? UK inflation increases
? Alternatively, high unemployment in US causes reduction in US income.
Hence, decrease in demand for UK goods.
? Thereby, production of goods reduced in UK causing unemployment in UK
? US exports unemployment to UK
Example
2-10
The Flexible Exchange Rate Regime: 1973-Present
? Flexible exchange rates were declared acceptable to the
IMF members.
? Central banks were allowed to intervene in the exchange rate
markets to iron out unwarranted volatilities.
? Gold was abandoned as an international reserve asset.
? Non-oil-exporting countries and less-developed
countries were given greater access to IMF funds.
? In a freely floating exchange rate system, exchange rates
are determined solely by market forces.
? Pros: Each country may become more insulated against
the economic problems in other countries.
? Pros: Central bank interventions that may affect the
economy unfavorably are no longer needed.
Freely Floating
Exchange Rate System
? Pros: Governments are not restricted by
exchange rate boundaries when setting new
policies.
? Pros: Less capital flow restrictions are needed,
thus enhancing the efficiency of the financial
market.
Freely Floating Exchange Rate
System
? Cons: MNCs may need to devote substantial
resources to managing their exposure to
exchange rate fluctuations.
? Cons: The country that initially experienced
economic problems (such as high inflation,
increasing unemployment rate) may have its
problems compounded.
Freely Floating Exchange Rate
System
Example (Pros)
? Assume there are only 2 countries in world (US,
UK) and have a floating exchange rate
? US inflation increase, UK inflation const.
US imports increase, US exports decrease
? Hence, demand for GBP increases, GBP
appreciates
? So UK products become costly for US consumer
? Price of goods is unchanged in UK
? Demand US goods in UK increases
Example (Cons)
? Assume there are only 2 countries in world (US, UK) and have a
floating exchange rate
? US inflation increase, UK inflation const.
? US$ depreciates, US imports become costlier
? US finished products become costlier, hence difficult to compete
with UK products
? Also if high unemployment, imports decrease, US$ appreciates
? As US$ appreciates, demand for foreign goods increases causing
further compounding of problems
? In a managed (or “dirty”) float exchange rate
system, exchange rates are allowed to move
freely on a daily basis and no official boundaries
exist. However, governments may intervene to
prevent the rates from moving too much in a
certain direction.
? Cons: A government may manipulate its
exchange rates such that its own country
benefits at the expense of others.
Managed Float Exchange Rate
System
? In a pegged exchange rate system, the home
currency’s value is pegged to a foreign currency
or to some unit of account, and moves in line
with that currency or unit against other
currencies.
? The European Economic Community’s snake
arrangement (1972-1979) pegged the currencies
of member countries within established limits of
each other.
Pegged Exchange Rate System
? The European Monetary System which followed
in 1979 held the exchange rates of member
countries together within specified limits and
also pegged them to a European Currency Unit
(ECU) through the exchange rate mechanism
(ERM).
? The ERM experienced severe problems in 1992, as
economic conditions and goals varied among member
countries.
Pegged Exchange Rate System
? In 1994, Mexico’s central bank pegged the peso
to the U.S. dollar, but allowed a band within
which the peso’s value could fluctuate against
the dollar.
? By the end of the year, there was substantial
downward pressure on the peso, and the central bank
allowed the peso to float freely.
Pegged Exchange Rate System
Currency Boards
? A currency board is a system for maintaining the
value of the local currency with respect to some
other specified currency.
? For example, Hong Kong has tied the value of the
Hong Kong dollar to the U.S. dollar (HK$7.8 = $1)
since 1983, while Argentina has tied the value of its
peso to the U.S. dollar (1 peso = $1) since 1991.
? In 2002, devalued 1 peso = $0.71 but as supply was
more than demand, could not hold on to peg and
changed to floating
Currency Boards
? For a currency board to be successful, it must
have credibility in its promise to maintain the
exchange rate.
? It has to intervene to defend its position against
the pressures exerted by economic conditions, as
well as by speculators who are betting that the
board will not be able to support the specified
exchange rate.
Exposure of a Pegged Currency to Interest
Rate Movements
? A country that uses a currency board does not
have complete control over its local interest
rates, as the rates must be aligned with the
interest rates of the currency to which the local
currency is tied.
? Note that the two interest rates may not be
exactly the same because of different risks.
? A currency that is pegged to another currency
will have to move in tandem with that currency
against all other currencies.
? So, the value of a pegged currency does not
necessarily reflect the demand and supply
conditions in the foreign exchange market, and
may result in uneven trade or capital flows.
Exposure of a Pegged Currency to Exchange
Rate Movements
2-24
Fixed versus Flexible
Exchange Rate Regimes
? Arguments in favor of flexible exchange rates:
? Easier external adjustments.
? National policy autonomy.
? Arguments against flexible exchange rates:
? Exchange rate uncertainty may hamper international trade.
? No safeguards to prevent crises.
Dollarization
? Dollarization refers to the replacement of a local
currency with U.S. dollars.
? Dollarization goes beyond a currency board, as
the country no longer has a local currency.
? For example, Ecuador implemented
dollarization in 2000.
€
A Single European Currency
? In 1991, the Maastricht treaty called for a single
European currency. On Jan 1, 1999, the euro
was adopted by Austria, Belgium, Finland,
France, Germany, Ireland, Italy, Luxembourg,
Netherlands, Portugal, and Spain. Greece joined
the system in 2001.
? By 2002, the national currencies of the 12
participating countries will be withdrawn and
completely replaced with the euro.
? Within the euro-zone, cross-border trade and
capital flows will occur without the need to
convert to another currency.
? European monetary policy is also consolidated
because of the single money supply. The
Frankfurt-based European Central Bank (ECB)
is responsible for setting the common monetary
policy.
€
A Single European Currency
? The ECB aims to control inflation in the
participating countries and to stabilize the euro
within reasonable boundaries.
? The common monetary policy may eventually
lead to more political harmony.
? Note that each participating country may have to
rely on its own fiscal policy (tax and
government expenditure decisions) to help solve
local economic problems.
€
A Single European Currency
? As currency movements among the European
countries will be eliminated, there should be an
increase in all types of business arrangements,
more comparable product pricing, and more
trade flows.
? It will also be easier to compare and conduct
valuations of firms across the participating
European countries.
€
A Single European Currency
? Stock and bond prices will also be more
comparable and there should be more cross-
border investing. However, non-European
investors may not achieve as much
diversification as in the past.
? Exchange rate risk and foreign exchange
transaction costs within the euro-zone will be
eliminated, while interest rates will have to be
similar.
€
A Single European Currency
? Since its introduction in 1999, the euro has
declined against many currencies.
? This weakness was partially attributed to capital
outflows from Europe, which was in turn
partially attributed to a lack of confidence in the
euro.
? Some countries had ignored restraint in favor of
resolving domestic problems, resulting in a lack
of solidarity.
€
A Single European Currency
Government Intervention
? Each country has a government agency (called
the central bank) that may intervene in the
foreign exchange market to control the value of
the country’s currency.
? In the United States, the Federal Reserve System
(Fed) is the central bank.
Government Intervention
? Central banks manage exchange rates
? to smooth exchange rate movements,
? to establish implicit exchange rate boundaries, and/or
? to respond to temporary disturbances.
? Often, intervention is overwhelmed by market
forces. However, currency movements may be
even more volatile in the absence of
intervention.
? Direct intervention refers to the exchange of
currencies that the central bank holds as reserves
for other currencies in the foreign exchange
market.
? Direct intervention is usually most effective
when there is a coordinated effort among central
banks.
Government Intervention
Government Intervention
Quantity of £
S
1
D
1
D
2
Value
of £
V
1
V
2
Fed exchanges $ for £
to strengthen the £
Quantity of £
S
2
D
1
Value
of £
V
2
V
1
Fed exchanges £ for $
to weaken the £
S
1
? When a central bank intervenes in the foreign
exchange market without adjusting for the
change in money supply, it is said to engaged in
nonsterilized intervention.
? In a sterilized intervention, Treasury securities
are purchased or sold at the same time to
maintain the money supply.
Government Intervention
Nonsterilized Intervention
Federal Reserve
Banks participating
in the foreign
exchange market
$ C$
To Strengthen
the C$:
Federal Reserve
Banks participating
in the foreign
exchange market
$ C$
To Weaken the
C$:
Sterilized Intervention
Federal Reserve
Banks participating
in the foreign
exchange market
$ C$
To Strengthen
the C$:
Federal Reserve
Banks participating
in the foreign
exchange market
$ C$
To Weaken the
C$:
$
Financial
institutions
that invest
in Treasury
securities
T- securities
Financial
institutions
that invest
in Treasury
securities
$
T- securities
? Some speculators attempt to determine when the
central bank is intervening, and the extent of the
intervention, in order to capitalize on the
anticipated results of the intervention effort.
Government Intervention
? Central banks can also engage in indirect
intervention by influencing the factors that
determine the value of a currency.
? For example, the Fed may attempt to increase
interest rates (and hence boost the dollar’s
value) by reducing the U.S. money supply.
? Note that high interest rates adversely affects local
borrowers.
Government Intervention
? Governments may also use foreign exchange
controls (such as restrictions on currency
exchange) as a form of indirect intervention.
Government Intervention
Exchange Rate Target Zones
? Many economists have criticized the present
exchange rate system because of the wide
swings in the exchange rates of major
currencies.
? Some have suggested that target zones be used,
whereby an initial exchange rate will be
established with specific boundaries (that are
wider than the bands used in fixed exchange rate
systems).
Exchange Rate Target Zones
? The ideal target zone should allow rates to
adjust to economic factors without causing wide
swings in international trade and fear in the
financial markets.
? However, the actual result may be a system no
different from what exists today.
Intervention as a Policy Tool
? Like tax laws and money supply, the exchange
rate is a tool which a government can use to
achieve its desired economic objectives.
? A weak home currency can stimulate foreign
demand for products, and hence local jobs.
However, it may also lead to higher inflation.
Intervention as a Policy Tool
? A strong currency may cure high inflation, since
the intensified foreign competition should cause
domestic producers to refrain from increasing
prices. However, it may also lead to higher
unemployment.
Impact of Government Actions on Exchange Rates
Government Intervention in
Foreign Exchange Market
Government Monetary
and Fiscal Policies
Relative Interest
Rates
Relative Inflation
Rates
Relative National
Income Levels
International
Capital Flows
Exchange Rates
International
Trade
Tax Laws,
etc.
Quotas,
Tariffs, etc.
Government
Purchases & Sales
of Currencies
Impact of Central Bank Intervention
on an MNC’s Value
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¿
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¦
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)
¦
¦
`
¹
¦
¦
¹
¦
¦
´
¦
+
×
=
n
t
t
m
j
t j t j
k
1 =
1
, ,
1
ER E CF E
= Value
E (CF
j,t
) = expected cash flows in currency j to be received by
the U.S. parent at the end of period t
E (ER
j,t
) = expected exchange rate at which currency j can be
converted to dollars at the end of period t
k = weighted average cost of capital of the parent
Direct Intervention
Indirect Intervention
2-49
The Mexican Peso Crisis
? On 20 December, 1994, the Mexican
government announced a plan to devalue the
peso against the dollar by 14 percent.
? This decision changed currency trader’s
expectations about the future value of the peso.
? They stampeded for the exits.
? In their rush to get out the peso fell by as much
as 40 percent.
2-50
The Mexican Peso Crisis
? The Mexican Peso crisis is unique in that it
represents the first serious international financial
crisis touched off by cross-border flight of
portfolio capital.
? Two lessons emerge:
? It is essential to have a multinational safety net in
place to safeguard the world financial system from
such crises.
? An influx of foreign capital can lead to an
overvaluation in the first place.
The Asian Currency Crisis
? The Asian currency crisis turned out to be far more serious than
the Mexican peso crisis in terms of the extent of the contagion
and the severity of the resultant economic and social costs.
? Many firms with foreign currency bonds were forced into
bankruptcy.
? The region experienced a deep, widespread recession.
2-52
Currency Crisis Explanations
? In theory, a currency’s value mirrors the fundamental strength
of its underlying economy, relative to other economies. In the
long run.
? In the short run, currency trader’s expectations play a much
more important role.
? In today’s environment, traders and lenders, using the most
modern communications, act by fight-or-flight instincts. For
example, if they expect others are about to sell Brazilian reals
for U.S. dollars, they want to “get to the exits first”.
? Thus, fears of depreciation become self-fulfilling prophecies.
Chapter Objectives
? To explain the conditions that will result in various
forms of international arbitrage, along with the
realignments that will occur in response
? To explain the concept of interest rate parity, and how it
prevents arbitrage opportunities.
Chapter 7: International Arbitrage And
Interest Rate Parity
? International Arbitrage
? Locational Arbitrage
? Triangular Arbitrage
? Covered Interest Arbitrage
? Comparison of Arbitrage Effects
? Interest Rate Parity (IRP)
? Derivation of IRP
? Determining the Forward Premium
? Graphic Analysis of IRP
? Test for the Existence of IRP
? Interpretation of IRP
? Does IRP Hold?
Agenda
International Arbitrage
? Arbitrage can be loosely defined as capitalizing on a
discrepancy in quoted prices. Often, the funds invested
are not tied up and no risk is involved
? In response to the imbalance in demand and supply
resulting from arbitrage activity, prices will realign very
quickly, such that no further risk-free profits can be
made
? Locational arbitrage is possible when a bank’s buying
price (bid price) is higher than another bank’s selling
price (ask price) for the same currency
? Example:
Bank C Bid Ask Bank D Bid Ask
NZ$ $.635 $.640 NZ$ $.645 $.650
Buy NZ$ from Bank C @ $.640, and sell it to Bank D @ $.645.
Profit = $.005/NZ$.
International Arbitrage
? Triangular arbitrage is possible when a cross exchange
rate quote differs from the rate calculated from spot
rates.
? Example: Bid Ask
British pound (£) $1.60 $1.61
Malaysian ringgit (MYR) $.200 $.202
£ MYR8.1 MYR8.2
Buy £ @ $1.61, convert @ MYR8.1/£, then sell MYR @ $.200.
Profit = $.01/£. (8.1×.2=1.62)
International Arbitrage
? When the exchange rates of the currencies are not in
equilibrium, triangular arbitrage will force them back
into equilibrium.
International Arbitrage
$
MYR £
Value of £
in $
Value of
MYR in $
Value of
£ in MYR
? Covered interest arbitrage is the process of
capitalizing on the interest rate differential between two
countries, while covering for exchange rate risk.
? Covered interest arbitrage tends to force a relationship
between forward rate premiums and interest rate
differentials.
International Arbitrage
? Example:
£ spot rate = 90-day forward rate = $1.60
U.S. 90-day interest rate = 2%
U.K. 90-day interest rate = 4%
Borrow $ at 3%, or use existing funds which are earning interest at
2%. Convert $ to £ at $1.60/£ and engage in a 90-day forward
contract to sell £ at $1.60/£. Lend £ at 4%.
International Arbitrage
? Locational arbitrage ensures that quoted
exchange rates are similar across banks in
different locations.
? Triangular arbitrage ensures that cross exchange
rates are set properly.
? Covered interest arbitrage ensures that forward
exchange rates are set properly.
International Arbitrage
? Any discrepancy will trigger arbitrage, which
will then eliminate the discrepancy. Arbitrage
thus makes the foreign exchange market more
orderly.
International Arbitrage
Interest Rate Parity (IRP)
? Market forces cause the forward rate to differ
from the spot rate by an amount that is sufficient
to offset the interest rate differential between the
two currencies.
? Then, covered interest arbitrage is no longer
feasible, and the equilibrium state achieved is
referred to as interest rate parity (IRP).
Derivation of IRP
? When IRP exists, the rate of return achieved from
covered interest arbitrage should equal the rate of return
available in the home country.
? End-value of a $1 investment in covered interest
arbitrage = (1/S) × (1+i
F
) × F
= (1/S) × (1+i
F
) × [S × (1+p)]
= (1+i
F
) × (1+p)
where p is the forward premium.
Derivation of IRP
? End-value of a $1 investment in the home
country = 1 + i
H
? Equating the two and rearranging terms:
p =
(1+i
H
)
– 1
(1+i
F
)
i.e.
forward
=
(1 + home interest rate)
– 1
premium (1 + foreign interest rate)
Determining the Forward Premium
Example:
? Suppose 6-month i
peso
= 6%, i
$
= 5%.
? From the U.S. investor’s perspective,
forward premium = 1.05/1.06 – 1 ~ - .0094
? If S = $.10/peso, then
6-month forward rate = S × (1 + p)
~ .10 × (1
_
.0094)
~ $.09906/peso
Determining the Forward Premium
? Note that the IRP relationship can be rewritten as
follows:
F – S
=
S(1+p) – S
= p =
(1+i
H
)
– 1 =
(i
H
–i
F
)
S S (1+i
F
) (1+i
F
)
? The approximated form, p ~ i
H
–i
F
, provides a reasonable
estimate when the interest rate differential is small.
Graphic Analysis of Interest Rate Parity
Interest Rate Differential (%)
home interest rate – foreign interest rate
Forward
Premium (%)
Forward
Discount (%)
- 2
- 4
2
4
1 3 - 1 - 3
IRP line
Graphic Analysis of Interest Rate Parity
Interest Rate Differential (%)
home interest rate – foreign interest rate
Forward
Premium (%)
Forward
Discount (%)
- 2
- 4
2
4
1 3 - 1 - 3
IRP line
Zone of potential
covered interest
arbitrage by local
investors
Zone of potential
covered interest
arbitrage by foreign
investors
Test for the Existence of IRP
? To test whether IRP exists, collect the actual
interest rate differentials and forward premiums
for various currencies. Pair up data that occur at
the same point in time and that involve the same
currencies, and plot the points on a graph.
? IRP holds when covered interest arbitrage is not
worthwhile.
Interpretation of IRP
? When IRP exists, it does not mean that both
local and foreign investors will earn the same
returns.
? What it means is that investors cannot use
covered interest arbitrage to achieve higher
returns than those achievable in their respective
home countries.
Does IRP Hold?
? Various empirical studies indicate that IRP
generally holds.
? While there are deviations from IRP, they are
often not large enough to make covered interest
arbitrage worthwhile.
? This is due to the characteristics of foreign
investments, including transaction costs,
political risk, and differential tax laws.
Considerations When Assessing IRP
Transaction Costs
i
H
– i
F
p
Zone of potential
covered interest
arbitrage by foreign
investors
Zone of
potential
covered interest
arbitrage by
local investors
IRP line
Zone where covered
interest arbitrage is not
feasible due to transaction
costs
Impact of Arbitrage on an MNC’s Value
( ) ( ) | |
( )
¿
¿
¦
¦
)
¦
¦
`
¹
¦
¦
¹
¦
¦
´
¦
+
×
=
n
t
t
m
j
t j t j
k
1 =
1
, ,
1
ER E CF E
= Value
E (CF
j,t
) = expected cash flows in currency j to be received by
the U.S. parent at the end of period t
E (ER
j,t
) = expected exchange rate at which currency j can be
converted to dollars at the end of period t
k = weighted average cost of capital of the parent
Forces of Arbitrage
CHAPTER 8 : Relationships between
Exchange Rates, Inflation and Interest Rates
PPP
? Theory: The price of a commodity of basket should be same in both
the countries after taking into consideration the exchange rate
? Absolute Form:
? Example: Price of a Standard commodity Basket:
? In US: $ 225
? In UK: £ 150
? Exchange Rate: $225 = £150 ? $1.5 = £1 ? ER = $1.5/£
? S($/£) = P
$
÷P
£
? Relative Form:
? Example: Inflation levels
? US: 5%
? UK: 7%
? Change in Exchange Rate: (5 – 7) i.e. 2% depreciation in £
? e = t
$
- t
£
Derivation of PPP
Assume,
Home country’s price index (P
h
) = foreign country’s price index (P
f
)
? When inflation occurs, the exchange rate will adjust to maintain PPP:
P
f
(1 + I
f
) (1 + e
f
) = P
h
(1 + I
h
)
where I
h
= inflation rate in the home country
I
f
= inflation rate in the foreign country
e
f
= % change in the value of the foreign currency
? Since P
h
= P
f
, solving for e
f
gives:
e
f
=
(1 + I
h
)
– 1
(1 + I
f
)
If I
h
= 5% & I
f
= 3%, e
f
= 1.05/1.03 – 1 = 1.94%
¬ From the home country perspective, both price indexes rise by 5%.
? When the inflation differential is small, the PPP relationship can be simplified as
e
f
~ I
h
_
I
f
Graphical Analysis of PPP
Inflation Rate Differential (%)
home inflation rate – foreign inflation rate
% A in the
foreign
currency’s spot
rate
- 2
- 4
2
4
1 3 - 1 - 3
PPP line
Graphical Analysis of PPP
Inflation Rate Differential (%)
home inflation rate – foreign inflation rate
% A in the
foreign
currency’s spot
rate
- 2
- 4
2
4
1 3 - 1 - 3
PPP line
Increased
purchasing
power of
foreign
goods
Decreased
purchasing
power of
foreign
goods
Testing the PPP Theory
? Graphical:
? Plot the actual inflation differential and exchange rate % change for two or
more countries on a graph.
? Statistical Test:
? Apply regression analysis to the historical exchange rates and inflation
differentials:
e
f
= a
0
+ a
1
{ (1+I
h
)/(1+I
f
) - 1 } + µ
? Test for
? Ho: a
0
= 0
? Ho: a
1
= 1
? Empirical studies indicates PPP is not perfect even in the long run
i.e. Both the Ho are rejected (even in the long run)
? Limitation of PPP Tests:
? Base Period Effect
PPP Tests for Selected Currencies
Based on annual data for 1971-2000
-4
-2
0
2
4
6
8
10
-20 -10 0 10 20 30 40
-8
-6
-4
-2
0
2
4
-10 -8 -6 -4 -2 0 2 4 6 8 10
-20
-15
-10
-5
0
5
-20 -10 0 10 20
I
U.S.
– I
U.K.
-15
-10
-5
0
5
10
-20 -10 0 10 20 30 40 50
e
£
I
U.S.
– I
Canada
e
C$
I
U.S.
– I
Japan
e
¥
I
U.S.
– I
Germany
e
DEM
Deviations from PPP
? Confounding effects of many other variables:
? Differentials in interest rates
? Income levels
? Risk
? Government controls
? Non-tradable Goods like Hair cut v/s Tradable Goods like
Camera Film
? Haircuts cost 10 times as much in the developed world as in the
developing world.
? Film, on the other hand, is a highly standardized commodity that is
actively traded across borders.
? Shipping costs, as well as tariffs and quotas can lead to
deviations from PPP
PPP Deviations and the Real Exchange Rate
? The real exchange rate: Actual exchange rate adjusted for
inflationary effects in the two countries of concern
? If PPP holds, (1 + e) = (1 + t
$
)/(1 + t
£
), then q = 1.
? If q < 1 competitiveness of domestic country improves with
currency depreciations.
? If q > 1 competitiveness of domestic country deteriorates with
currency depreciations.
) 1 )( 1 (
1
£
$
t
t
+ +
+
=
e
q
Real Exchange Rates for different currencies
Quarterly
Growth Rates
of Real
Exchange
Rates
Alternative Theories
? Big Mac Index: Prices of McDonald’s Big Mac Burger
in different countries
? Suggests $1 PPP of ¥169 and DM2.07
? Fundamental Equilibrium Exchange Rate(FEER)
? Rate that will generate current a/c deficit(surplus) equal to the
capital inflow(outflow)
? Strong correlation between a currency’s under or over-
valuation against dollar relative to its Big Mac, PPP and
Country’s Current A/c Deficit
International Fisher Effect (IFE)
Theory: According to the Fisher effect, nominal risk-
free interest rates contain a real rate of return and
an anticipated inflation
•An increase (decrease) in the expected rate of
inflation will cause a proportionate increase
(decrease) in the interest rate in the country
For the U.S., the Fisher effect is written as:
i
$
= µ
$
+ E(t
$
)
Where
µ
$
is the equilibrium expected “real” U.S. interest rate
E(t
$
) is the expected rate of U.S. inflation
i
$
is the equilibrium expected nominal U.S. interest rate
? The international Fisher effect (IFE) theory suggests
that currencies with higher interest rates will
depreciate because the higher rates reflect higher
expected inflation.
? Hence, investors hoping to capitalize on a higher
foreign interest rate should earn a return no better
than what they would have earned domestically.
Derivation
? The IFE states that
? The return on investment in Foreign Market should be
equal to the return on investment in Domestic Market
? Real Rate of Interests are equal
If the Fisher effect holds in the U.S.
i
$
= µ
$
+ E(t
$
)
and the Fisher effect holds in Japan,
i
¥
= µ
¥
+ E(t
¥
)
and if the real rates are the same in each country
µ
$
= µ
¥
then we get the International Fisher Effect
E(e) = i
$
- i
¥
.
? Also,
? r
f
= (1 + i
f
) (1 + e
f
) – 1
i
f
= interest rate in the foreign country
e
f
= % change in the foreign currency’s
value
? Setting r
f
= r
h
: (1 + i
f
) (1 + e
f
) – 1 = i
h
? Solving for e
f
:
e
f
=
(1 + i
h
) _
1
(1 + i
f
)
¬ If i
h
> i
f
, e
f
> 0 (foreign currency appreciates)
If i
h
< i
f
, e
f
< 0 (foreign currency depreciates)
If i
h
= 8% & i
f
= 9%, e
f
= 1.08/1.09 – 1 = - .92%
¬This will make the return on the foreign investment equal
to the domestic return
Example
? If the British rate on 6-month deposits were 2%
above the U.S. interest rate, the £ should
depreciate by approximately 2% over 6 months.
Then U.S. investors would earn about the same
return on British deposits as they would on U.S.
deposits.
Graphic Analysis of the International Fisher
Effect
Interest Rate Differential (%)
home interest rate – foreign interest rate
- 2
- 4
2
4
1 3 - 1 - 3
IFE line
% A in the
foreign
currency’s
spot rate
Higher returns
from investing
in foreign
deposits
Lower returns
from investing
in foreign
deposits
Graphic Analysis of the IFE
? The point of the IFE theory is that if a firm
periodically tries to capitalize on higher foreign
interest rates, it will achieve a yield that is
sometimes above and sometimes below the
domestic yield
? On the average, the firm would achieve a yield
similar to that by a corporation that makes
domestic deposits only
Why the IFE Does Not Occur
• Since the IFE is based on PPP, it will
not hold when PPP does not hold.
• For example, if there are factors other
than inflation that affect exchange rates,
the rates will not adjust in accordance
with the inflation differential.
Equilibrium Exchange Rate Relationships
S
(F - S)
E(e)
) -i (i
¥ $
t
$
- t
£
IR
P
PPP
FE FRPP
P
IFE FP
Chapter 9: Forecasting Exchange Rates
Chapter Objectives
? To explain how firms can benefit from
forecasting exchange rates;
? To describe the common techniques used for
forecasting; and
? To explain how forecasting performance can be
evaluated.
? MNCs need exchange rate forecasts for their:
? hedging decisions,
? short-term financing decisions,
? short-term investment decisions,
? capital budgeting decisions,
? long-term financing decisions, and
? earnings assessment.
Why Firms Forecast
Exchange Rates
Forecasting Techniques
? The numerous methods available for forecasting
exchange rates can be categorized into four
general groups:
? technical,
? fundamental,
? market-based,and
? mixed.
? Technical forecasting involves the use of
historical data to predict future values. It
includes statistical analysis and time series
models.
? Speculators may find the models useful for
predicting day-to-day movements.
? However, since they typically focus on the near
future and rarely provide point/range estimates,
they are of limited use to MNCs.
Technical Forecasting
? Technical analysis looks for patterns in the past
behavior of exchange rates.
? Clearly it is based upon the premise that history
repeats itself.
? Thus it is at odds with the EMH
Technical Forecasting
Technical Forecasting Example
Tomorrow Kansas Co. has to pay 10 million Mexican pesos for supplies that it
recently from Mexico. Today, the peso has appreciated by 3 percent against the
dollar. Kansas Co. could send the payment today so that it would avoid the effects
of any additional appreciation tomorrow. Based on an analysis of historical time
series, Kansas has determined that whenever the peso appreciates against the dollar
by more than 1 percent, it experiences a reversal of about 60 percent on the
following day. That is,
e
t+1
= e
t
x (- 60%) when e
t
> 1%
Applying this tendency to the current situation in which the peso appreciated by 3
percent today, Kansas Co. forecasts that tomorrow’s exchange rate will change by
e
t+1
= e
t
x (- 60%)
= (3%) x (- 60%)
= - 1.8%
? Fundamental forecasting is based on the
fundamental relationships between economic
variables and exchange rates.
? A forecast may arise simply from a subjective
assessment of the factors that affect exchange
rates.
? A forecast may be based on quantitative
measurements (with the aid of regression
models and sensitivity analysis) too.
Fundamental Forecasting
Fundamental Forecasting
Involves econometrics to develop models that
use a variety of explanatory variables. This
involves three steps:
step 1: Estimate the structural model.
step 2: Estimate future parameter values.
step 3: Use the model to develop forecasts.
The downside is that fundamental models do
not work any better than the forward rate model
or the random walk model.
Fundamental Forecasting Example -
Regression
Objective : forecast the percentage change in the British
pound with respect to the US dollar during the next quarter.
Assume the forecast is dependent only two factors that
affect the pound’s value: relative inflation, relative income
growth
The regression equation can be defined as:
BP
t
= b
0
+ b
1
INF
t-1
+ b
2
INC
t-1
+ µ
t
Assume b
0
= .002, b
1
= .8 and b
2
= 1.0, INF
t-1
= 4%, INC
t-1
= 2%
BP
t
= .002 + .8(4%) + 1(2%)
= 5.4%
Fundamental Forecasting Example –
Sensitivity Analysis
e
t
= a
0
+ a
1
INT
t
+ a
2
INF
t-1
+ µ
t
Assume a
0
= .001, a
1
= - .7, a
2
= .6
Assume that Phoenix Corp. has developed the following probability
distribution for INT
t
Probability Possible
Outcome
20% -3%
50% -4%
30% -5%
A separate forecast of e
t
can be developed from each possible
outcome of INT
t
as follows:
Forecast of INT Forecast of e
t
Probability
-3% .1% + (-.7)(-3%) + .6(1%) = 2.8% 20%
-4% .1% + (-.7)(-4%) + .6(1%) = 3.5% 50%
-5% .1% + (-.7)(-5%) + .6(1%) = 4.2% 30%
Fundamental Forecasting Example – Use of
PPP
According to PPP, the currency of the relatively inflated country will depreciate
by an amount that reflects that country’s inflation differential.
Example: The US inflation rate is expected to be 1 percent over the next year,
while the Australian inflation rate is expected to be 6 percent. According to
PPP, the Australian dollar’s exchange rate should change as follows:
e
f
= (1 + I
US
) - 1
(1 + I
f
)
= 1.01 - 1
1.06
= -4.7%
E(S
t
+1) = S
t
(1+e
f
)
= $.50 [ 1 + (-.047)]
= $.4765
? Known relationships like the PPP can be used
for the regression models. However, problems
may arise. In the case of PPP:
? the timing of the impact of inflation on trade behavior
is not known for sure,
? prices may be measured inaccurately,
? trade barriers may disrupt the trade patterns that
should emerge, and
? other influential factors may exist.
Fundamental Forecasting
? In general, fundamental forecasting is limited by :
? the uncertain timing of the impact of the factors,
? the need for forecasts for factors with instantaneous
impact,
? the possibility that other relevant factors may be omitted
from the model, and
? changes in the sensitivity of currency movements to
each factor over time.
Fundamental Forecasting
? Market-based forecasting involves developing
forecasts from market indicators.
? Usually, either the spot rate or the forward rate
is used, since speculation should push the rates
to the level that reflect the market expectation of
the future exchange rate.
Market-Based Forecasting
Market-Based Forecasting: Example
? If the one year forward rate of the Australian
dollar is $0.63, while the spot rate is $0.60, the
expected percentage change in the Australian
dollar is
? E(e) = p
= (F/S)-1
=(0.63/0.60)-1
=0.05, or 5%
? Since forward contracts have low trading
volumes and are not widely quoted, the interest
rates on risk-free instruments can be used to
determine what the forward rates should be
according to IRP for long-term forecasting.
Market-Based Forecasting
Mixed Forecasting
? Mixed forecasting refers to the use of a
combination of forecasting techniques.
? The actual forecast is a weighted average of the
various forecasts developed.
Forecasting Services
? The corporate need to forecast currency values
has prompted some consulting firms and
investment banks to offer forecasting services.
? Advice on hedging and international cash
management, and assessment of the firm’s
exposure to exchange rate risk, may be provided
too.
? One way to determine whether a forecasting
service is valuable is to compare the accuracy of
its forecasts with the accuracy of publicly
available and free forecasts.
Forecasting Services
Evaluation of Forecast Performance
? An MNC that forecasts exchange rates should
monitor its performance over time to determine
whether its forecasting procedure is satisfactory.
? The MNC may also want to compare the various
forecasting methods.
Evaluation of Forecast Performance
? One measure of forecast performance is the
absolute forecast error as a percentage of the
realized value:
| forecasted value – realized value |
realized value
? Over time, MNCs are likely to have more
confidence in their forecasts when they know
the mean error for their past forecasts.
Evaluation of Forecast Performance
Using the Forward Rate as a Forecast for the British Pound
0.00
0.05
0.10
0.15
0.20
0.25
0.30
0.35
1975 1980 1985 1990 1995 2000
A
b
s
o
l
u
t
e
F
o
r
e
c
a
s
t
E
r
r
o
r
(
$
)
Evaluation of Forecast Performance
? The ability to forecast currency values may vary
with the currency of concern.
? In particular, the value of a less volatile currency
is likely to be forecasted more accurately.
Mean Absolute Forecast Error
Currency as a Percent of the Realized Value
1974-1998 1974-1984 1985-1998
British pound 4.61 % 5.06 % 4.21
%
Canadian dollar 1.73 1.70 1.75
Japanese yen 5.60 5.22 5.93
Swiss franc 5.69 5.81 5.58
Evaluation of Forecast Performance
Forecast Bias
? If the forecast errors are consistently positive or
negative over time, then there is a bias in the
forecasting procedure.
Forecast Bias
Using the Forward Rate as a Forecast for the British Pound
$1.00
$1.20
$1.40
$1.60
$1.80
$2.00
$2.20
$2.40
$2.60
1975 1980 1985 1990 1995 2000
Forward Rate
Realized
Spot Rate
Forecast Bias
? The following regression model can be used to
test for forecast bias:
realized = a
0
+ a
1
´ forecast + µ
? If a predictor is found to be biased, the estimated
a
0
and a
1
values can be used to correct the
systematic error.
Graphic Evaluation of Forecast Performance
Perfect
forecast line
x z
x
z
R
e
a
l
i
z
e
d
V
a
l
u
e
Predicted Value
Region of downward bias
(underestimating)
Region of
upward bias
(overestimating)
Graphic Evaluation of Forecast Performance
Using the Forward Rate as a Forecast for the British Pound
R
e
a
l
i
z
e
d
S
p
o
t
R
a
t
e
$1.00
$1.50
$2.00
$2.50
$1.00 $1.50 $2.00 $2.50
Forecast (Forward Rate)
Perfect
Forecast
Line
Graphic Evaluation
of Forecast Performance
? If the points appear to be scattered evenly on
both sides of the perfect forecast line, then the
forecasts are said to be unbiased.
? Note that a more thorough assessment can be
conducted by separating the entire period into
subperiods.
Comparison of
Forecasting Techniques
? The different forecasting techniques can be
evaluated
? graphically - by comparing the distances from the
perfect forecast line, or
? statistically - by computing the mean of the absolute
forecast errors, and then using a t-test or a
nonparametric test to determine whether there is a
significant difference in the accuracy of the
forecasting techniques.
Efficient Markets Approach
Financial Markets are efficient if prices
reflect all available and relevant information.
If this is so, exchange rates will only change
when new information arrives, thus:
S
t
= E[S
t+1
]
and
F
t
= E[S
t+1
| I
t
]
Predicting exchange rates using the
efficient markets approach is affordable and
is hard to beat.
Forecasting Under Market Efficiency
? If the foreign exchange market is weak-form
efficient, then the current exchange rates already
reflect historical information. So, technical
analysis would not be useful.
? If the market is semistrong-form efficient, then
all the relevant public information is already
reflected in the current exchange rates.
? If the market is strong-form efficient, then all the
relevant public and private information is
already reflected in the current exchange rates.
? Foreign exchange markets are generally found
to be at least semistrong-form efficient.
Forecasting Under Market Efficiency
? Nevertheless, MNCs may still find forecasting
worthwhile, since their goal is not to earn
speculative profits but to use exchange rate
forecasts to implement policies.
? In particular, MNCs may need to determine the
range of possible exchange rates in order to
assess the degree to which their operating
performance could be affected.
Forecasting Under Market Efficiency
Exchange Rate Volatility
? MNCs also forecast exchange rate volatility.
This enables them to specify a range
(confidence interval) and develop best-case and
worst-case scenarios along with their point
estimate forecasts.
? Popular methods for forecasting volatility
include:
? the use of recent exchange rate volatility,
Exchange Rate Volatility
? the use of a historical time series of volatilities (there
may be a pattern in how the exchange rate volatility
changes over time), and
? the derivation of the exchange rate’s implied
standard deviation from the currency option pricing
model.
Exchange Rate Volatility-Example
? Harp, Inc. an MNC imports products from Canada.
Current spot rate of Canadian $ is 0.70. Harp determines
the S.D. of Canadian $ over the last 12 months is 2%.
? Thus assuming the movements are normally distributed,
it expects that there is a 68% chance that the actual value
will be in a range from $0.686 to $0.714(1 S.D.) and
there is a 95% chance that the actual value will be in a
range from $0.672 to $0.728(2 S.D)
Application of Exchange Rate Forecasting
to the Asian Crisis
? Before the crisis, the spot rate served as a
reasonable predictor, because the central banks
were maintaining a somewhat stable value for
their respective currencies.
? But even after the crisis began, it is unlikely that
the degree of depreciation could have been
accurately predicted by the usual models.
Application of Exchange Rate Forecasting
to the Asian Crisis
? The large amount of foreign investment and the
fear of a massive selloff of the currencies played
key roles in the sharp decline of the Asian
currency values.
? However, these two factors cannot be easily
incorporated into a fundamental forecasting
model in a manner that will precisely identify
the timing and magnitude of currency
depreciation.
Impact of Forecasted Exchange Rates
on an MNC’s Value
( ) ( ) | |
( )
¿
¿
¦
¦
)
¦
¦
`
¹
¦
¦
¹
¦
¦
´
¦
+
×
=
n
t
t
m
j
t j t j
k
1 =
1
, ,
1
ER E CF E
= Value
E (CF
j,t
) = expected cash flows in currency j to be received by
the U.S. parent at the end of period t
E (ER
j,t
) = expected exchange rate at which currency j can be
converted to dollars at the end of period t
k = weighted average cost of capital of the parent
Technical Forecasting
Fundamental Forecasting
Market-based Forecasting
Mixed Forecasting
? Why Firms Forecast Exchange Rates
? Forecasting Techniques
? Technical Forecasting
? Fundamental Forecasting
? Market-Based Forecasting
? Mixed Forecasting
? Forecasting Services
? Performance of Forecasting Services
Chapter Review
Chapter Review
? Evaluation of Forecast Performance
? Forecast Accuracy Over Time
? Forecast Accuracy Among Currencies
? Search for Forecast Bias
? Statistical Test of Forecast Bias
? Graphic Evaluation of Forecast Performance
? Comparison of Forecasting Techniques
Chapter Review
? Forecasting Under Market Efficiency
? Exchange Rate Volatility
? Application of Exchange Rate Forecasting to the
Asian Crisis
? How Exchange Rate Forecasting Affects an
MNC’s Value
doc_828243773.pptx
The objective of this presentation about the exchange rate systems used by various governments, explain how governments can use direct and indirect intervention to influence exchange rates, to explain how government intervention in the foreign exchange market can affect economic conditions.
Chapter 6 - Government Influence
On Exchange Rates
Chapter Objectives
? To describe the exchange rate systems used by
various governments
? To explain how governments can use direct and
indirect intervention to influence exchange rates
? To explain how government intervention in the
foreign exchange market can affect economic
conditions.
2-3
Evolution of the
International Monetary System
? Bimetallism: Before 1875
? Classical Gold Standard: 1875-1914
? Interwar Period: 1915-1944
? Bretton Woods System: 1945-1972
? The Flexible Exchange Rate Regime: 1973-Present
2-4
Bretton Woods System:
1945-1972
? Named for a 1944 meeting of 44 nations at Bretton Woods,
New Hampshire.
? The purpose was to design a postwar international
monetary system.
? The goal was exchange rate stability without the gold
standard.
? The result was the creation of the IMF and the World Bank.
2-5
Bretton Woods System:
1945-1972
? Under the Bretton Woods system, the U.S. dollar was
pegged to gold at $35 per ounce and other currencies
were pegged to the U.S. dollar.
? Each country was responsible for maintaining its
exchange rate within ±1% of the adopted par value by
buying or selling foreign reserves as necessary.
? The Bretton Woods system was a dollar-based gold
exchange standard.
Exchange Rate Systems
? Exchange rate systems can be classified
according to the degree to which the rates are
controlled by the government.
? Exchange rate systems normally fall into one of
the following categories:
? fixed
? freely floating
? managed float
? pegged
? In a fixed exchange rate system, exchange rates are
either held constant or allowed to fluctuate only
within very narrow bands.
? The Bretton Woods era (1944-1971) fixed each
currency’s value in terms of gold.
? The 1971 Smithsonian Agreement which followed
merely adjusted the exchange rates and expanded
the fluctuation boundaries. The system was still
fixed.
Fixed Exchange Rate System
? Pros: Work becomes easier for the MNCs.
? Cons: Governments may revalue their
currencies. In fact, the dollar was devalued more
than once after the U.S. experienced balance of
trade deficits.
? Cons: Each country may become more
vulnerable to the economic conditions in other
countries.
Fixed Exchange Rate System
? Assume there are only 2 countries in world (US, UK) and have a fixed
exchange rate
? US inflation increase, UK inflation const. US imports increase, US exports
decrease
? US production decreases, unemployment increases
? UK inflation increases
? Alternatively, high unemployment in US causes reduction in US income.
Hence, decrease in demand for UK goods.
? Thereby, production of goods reduced in UK causing unemployment in UK
? US exports unemployment to UK
Example
2-10
The Flexible Exchange Rate Regime: 1973-Present
? Flexible exchange rates were declared acceptable to the
IMF members.
? Central banks were allowed to intervene in the exchange rate
markets to iron out unwarranted volatilities.
? Gold was abandoned as an international reserve asset.
? Non-oil-exporting countries and less-developed
countries were given greater access to IMF funds.
? In a freely floating exchange rate system, exchange rates
are determined solely by market forces.
? Pros: Each country may become more insulated against
the economic problems in other countries.
? Pros: Central bank interventions that may affect the
economy unfavorably are no longer needed.
Freely Floating
Exchange Rate System
? Pros: Governments are not restricted by
exchange rate boundaries when setting new
policies.
? Pros: Less capital flow restrictions are needed,
thus enhancing the efficiency of the financial
market.
Freely Floating Exchange Rate
System
? Cons: MNCs may need to devote substantial
resources to managing their exposure to
exchange rate fluctuations.
? Cons: The country that initially experienced
economic problems (such as high inflation,
increasing unemployment rate) may have its
problems compounded.
Freely Floating Exchange Rate
System
Example (Pros)
? Assume there are only 2 countries in world (US,
UK) and have a floating exchange rate
? US inflation increase, UK inflation const.
US imports increase, US exports decrease
? Hence, demand for GBP increases, GBP
appreciates
? So UK products become costly for US consumer
? Price of goods is unchanged in UK
? Demand US goods in UK increases
Example (Cons)
? Assume there are only 2 countries in world (US, UK) and have a
floating exchange rate
? US inflation increase, UK inflation const.
? US$ depreciates, US imports become costlier
? US finished products become costlier, hence difficult to compete
with UK products
? Also if high unemployment, imports decrease, US$ appreciates
? As US$ appreciates, demand for foreign goods increases causing
further compounding of problems
? In a managed (or “dirty”) float exchange rate
system, exchange rates are allowed to move
freely on a daily basis and no official boundaries
exist. However, governments may intervene to
prevent the rates from moving too much in a
certain direction.
? Cons: A government may manipulate its
exchange rates such that its own country
benefits at the expense of others.
Managed Float Exchange Rate
System
? In a pegged exchange rate system, the home
currency’s value is pegged to a foreign currency
or to some unit of account, and moves in line
with that currency or unit against other
currencies.
? The European Economic Community’s snake
arrangement (1972-1979) pegged the currencies
of member countries within established limits of
each other.
Pegged Exchange Rate System
? The European Monetary System which followed
in 1979 held the exchange rates of member
countries together within specified limits and
also pegged them to a European Currency Unit
(ECU) through the exchange rate mechanism
(ERM).
? The ERM experienced severe problems in 1992, as
economic conditions and goals varied among member
countries.
Pegged Exchange Rate System
? In 1994, Mexico’s central bank pegged the peso
to the U.S. dollar, but allowed a band within
which the peso’s value could fluctuate against
the dollar.
? By the end of the year, there was substantial
downward pressure on the peso, and the central bank
allowed the peso to float freely.
Pegged Exchange Rate System
Currency Boards
? A currency board is a system for maintaining the
value of the local currency with respect to some
other specified currency.
? For example, Hong Kong has tied the value of the
Hong Kong dollar to the U.S. dollar (HK$7.8 = $1)
since 1983, while Argentina has tied the value of its
peso to the U.S. dollar (1 peso = $1) since 1991.
? In 2002, devalued 1 peso = $0.71 but as supply was
more than demand, could not hold on to peg and
changed to floating
Currency Boards
? For a currency board to be successful, it must
have credibility in its promise to maintain the
exchange rate.
? It has to intervene to defend its position against
the pressures exerted by economic conditions, as
well as by speculators who are betting that the
board will not be able to support the specified
exchange rate.
Exposure of a Pegged Currency to Interest
Rate Movements
? A country that uses a currency board does not
have complete control over its local interest
rates, as the rates must be aligned with the
interest rates of the currency to which the local
currency is tied.
? Note that the two interest rates may not be
exactly the same because of different risks.
? A currency that is pegged to another currency
will have to move in tandem with that currency
against all other currencies.
? So, the value of a pegged currency does not
necessarily reflect the demand and supply
conditions in the foreign exchange market, and
may result in uneven trade or capital flows.
Exposure of a Pegged Currency to Exchange
Rate Movements
2-24
Fixed versus Flexible
Exchange Rate Regimes
? Arguments in favor of flexible exchange rates:
? Easier external adjustments.
? National policy autonomy.
? Arguments against flexible exchange rates:
? Exchange rate uncertainty may hamper international trade.
? No safeguards to prevent crises.
Dollarization
? Dollarization refers to the replacement of a local
currency with U.S. dollars.
? Dollarization goes beyond a currency board, as
the country no longer has a local currency.
? For example, Ecuador implemented
dollarization in 2000.
€
A Single European Currency
? In 1991, the Maastricht treaty called for a single
European currency. On Jan 1, 1999, the euro
was adopted by Austria, Belgium, Finland,
France, Germany, Ireland, Italy, Luxembourg,
Netherlands, Portugal, and Spain. Greece joined
the system in 2001.
? By 2002, the national currencies of the 12
participating countries will be withdrawn and
completely replaced with the euro.
? Within the euro-zone, cross-border trade and
capital flows will occur without the need to
convert to another currency.
? European monetary policy is also consolidated
because of the single money supply. The
Frankfurt-based European Central Bank (ECB)
is responsible for setting the common monetary
policy.
€
A Single European Currency
? The ECB aims to control inflation in the
participating countries and to stabilize the euro
within reasonable boundaries.
? The common monetary policy may eventually
lead to more political harmony.
? Note that each participating country may have to
rely on its own fiscal policy (tax and
government expenditure decisions) to help solve
local economic problems.
€
A Single European Currency
? As currency movements among the European
countries will be eliminated, there should be an
increase in all types of business arrangements,
more comparable product pricing, and more
trade flows.
? It will also be easier to compare and conduct
valuations of firms across the participating
European countries.
€
A Single European Currency
? Stock and bond prices will also be more
comparable and there should be more cross-
border investing. However, non-European
investors may not achieve as much
diversification as in the past.
? Exchange rate risk and foreign exchange
transaction costs within the euro-zone will be
eliminated, while interest rates will have to be
similar.
€
A Single European Currency
? Since its introduction in 1999, the euro has
declined against many currencies.
? This weakness was partially attributed to capital
outflows from Europe, which was in turn
partially attributed to a lack of confidence in the
euro.
? Some countries had ignored restraint in favor of
resolving domestic problems, resulting in a lack
of solidarity.
€
A Single European Currency
Government Intervention
? Each country has a government agency (called
the central bank) that may intervene in the
foreign exchange market to control the value of
the country’s currency.
? In the United States, the Federal Reserve System
(Fed) is the central bank.
Government Intervention
? Central banks manage exchange rates
? to smooth exchange rate movements,
? to establish implicit exchange rate boundaries, and/or
? to respond to temporary disturbances.
? Often, intervention is overwhelmed by market
forces. However, currency movements may be
even more volatile in the absence of
intervention.
? Direct intervention refers to the exchange of
currencies that the central bank holds as reserves
for other currencies in the foreign exchange
market.
? Direct intervention is usually most effective
when there is a coordinated effort among central
banks.
Government Intervention
Government Intervention
Quantity of £
S
1
D
1
D
2
Value
of £
V
1
V
2
Fed exchanges $ for £
to strengthen the £
Quantity of £
S
2
D
1
Value
of £
V
2
V
1
Fed exchanges £ for $
to weaken the £
S
1
? When a central bank intervenes in the foreign
exchange market without adjusting for the
change in money supply, it is said to engaged in
nonsterilized intervention.
? In a sterilized intervention, Treasury securities
are purchased or sold at the same time to
maintain the money supply.
Government Intervention
Nonsterilized Intervention
Federal Reserve
Banks participating
in the foreign
exchange market
$ C$
To Strengthen
the C$:
Federal Reserve
Banks participating
in the foreign
exchange market
$ C$
To Weaken the
C$:
Sterilized Intervention
Federal Reserve
Banks participating
in the foreign
exchange market
$ C$
To Strengthen
the C$:
Federal Reserve
Banks participating
in the foreign
exchange market
$ C$
To Weaken the
C$:
$
Financial
institutions
that invest
in Treasury
securities
T- securities
Financial
institutions
that invest
in Treasury
securities
$
T- securities
? Some speculators attempt to determine when the
central bank is intervening, and the extent of the
intervention, in order to capitalize on the
anticipated results of the intervention effort.
Government Intervention
? Central banks can also engage in indirect
intervention by influencing the factors that
determine the value of a currency.
? For example, the Fed may attempt to increase
interest rates (and hence boost the dollar’s
value) by reducing the U.S. money supply.
? Note that high interest rates adversely affects local
borrowers.
Government Intervention
? Governments may also use foreign exchange
controls (such as restrictions on currency
exchange) as a form of indirect intervention.
Government Intervention
Exchange Rate Target Zones
? Many economists have criticized the present
exchange rate system because of the wide
swings in the exchange rates of major
currencies.
? Some have suggested that target zones be used,
whereby an initial exchange rate will be
established with specific boundaries (that are
wider than the bands used in fixed exchange rate
systems).
Exchange Rate Target Zones
? The ideal target zone should allow rates to
adjust to economic factors without causing wide
swings in international trade and fear in the
financial markets.
? However, the actual result may be a system no
different from what exists today.
Intervention as a Policy Tool
? Like tax laws and money supply, the exchange
rate is a tool which a government can use to
achieve its desired economic objectives.
? A weak home currency can stimulate foreign
demand for products, and hence local jobs.
However, it may also lead to higher inflation.
Intervention as a Policy Tool
? A strong currency may cure high inflation, since
the intensified foreign competition should cause
domestic producers to refrain from increasing
prices. However, it may also lead to higher
unemployment.
Impact of Government Actions on Exchange Rates
Government Intervention in
Foreign Exchange Market
Government Monetary
and Fiscal Policies
Relative Interest
Rates
Relative Inflation
Rates
Relative National
Income Levels
International
Capital Flows
Exchange Rates
International
Trade
Tax Laws,
etc.
Quotas,
Tariffs, etc.
Government
Purchases & Sales
of Currencies
Impact of Central Bank Intervention
on an MNC’s Value
( ) ( ) | |
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¿
¿
¦
¦
)
¦
¦
`
¹
¦
¦
¹
¦
¦
´
¦
+
×
=
n
t
t
m
j
t j t j
k
1 =
1
, ,
1
ER E CF E
= Value
E (CF
j,t
) = expected cash flows in currency j to be received by
the U.S. parent at the end of period t
E (ER
j,t
) = expected exchange rate at which currency j can be
converted to dollars at the end of period t
k = weighted average cost of capital of the parent
Direct Intervention
Indirect Intervention
2-49
The Mexican Peso Crisis
? On 20 December, 1994, the Mexican
government announced a plan to devalue the
peso against the dollar by 14 percent.
? This decision changed currency trader’s
expectations about the future value of the peso.
? They stampeded for the exits.
? In their rush to get out the peso fell by as much
as 40 percent.
2-50
The Mexican Peso Crisis
? The Mexican Peso crisis is unique in that it
represents the first serious international financial
crisis touched off by cross-border flight of
portfolio capital.
? Two lessons emerge:
? It is essential to have a multinational safety net in
place to safeguard the world financial system from
such crises.
? An influx of foreign capital can lead to an
overvaluation in the first place.
The Asian Currency Crisis
? The Asian currency crisis turned out to be far more serious than
the Mexican peso crisis in terms of the extent of the contagion
and the severity of the resultant economic and social costs.
? Many firms with foreign currency bonds were forced into
bankruptcy.
? The region experienced a deep, widespread recession.
2-52
Currency Crisis Explanations
? In theory, a currency’s value mirrors the fundamental strength
of its underlying economy, relative to other economies. In the
long run.
? In the short run, currency trader’s expectations play a much
more important role.
? In today’s environment, traders and lenders, using the most
modern communications, act by fight-or-flight instincts. For
example, if they expect others are about to sell Brazilian reals
for U.S. dollars, they want to “get to the exits first”.
? Thus, fears of depreciation become self-fulfilling prophecies.
Chapter Objectives
? To explain the conditions that will result in various
forms of international arbitrage, along with the
realignments that will occur in response
? To explain the concept of interest rate parity, and how it
prevents arbitrage opportunities.
Chapter 7: International Arbitrage And
Interest Rate Parity
? International Arbitrage
? Locational Arbitrage
? Triangular Arbitrage
? Covered Interest Arbitrage
? Comparison of Arbitrage Effects
? Interest Rate Parity (IRP)
? Derivation of IRP
? Determining the Forward Premium
? Graphic Analysis of IRP
? Test for the Existence of IRP
? Interpretation of IRP
? Does IRP Hold?
Agenda
International Arbitrage
? Arbitrage can be loosely defined as capitalizing on a
discrepancy in quoted prices. Often, the funds invested
are not tied up and no risk is involved
? In response to the imbalance in demand and supply
resulting from arbitrage activity, prices will realign very
quickly, such that no further risk-free profits can be
made
? Locational arbitrage is possible when a bank’s buying
price (bid price) is higher than another bank’s selling
price (ask price) for the same currency
? Example:
Bank C Bid Ask Bank D Bid Ask
NZ$ $.635 $.640 NZ$ $.645 $.650
Buy NZ$ from Bank C @ $.640, and sell it to Bank D @ $.645.
Profit = $.005/NZ$.
International Arbitrage
? Triangular arbitrage is possible when a cross exchange
rate quote differs from the rate calculated from spot
rates.
? Example: Bid Ask
British pound (£) $1.60 $1.61
Malaysian ringgit (MYR) $.200 $.202
£ MYR8.1 MYR8.2
Buy £ @ $1.61, convert @ MYR8.1/£, then sell MYR @ $.200.
Profit = $.01/£. (8.1×.2=1.62)
International Arbitrage
? When the exchange rates of the currencies are not in
equilibrium, triangular arbitrage will force them back
into equilibrium.
International Arbitrage
$
MYR £
Value of £
in $
Value of
MYR in $
Value of
£ in MYR
? Covered interest arbitrage is the process of
capitalizing on the interest rate differential between two
countries, while covering for exchange rate risk.
? Covered interest arbitrage tends to force a relationship
between forward rate premiums and interest rate
differentials.
International Arbitrage
? Example:
£ spot rate = 90-day forward rate = $1.60
U.S. 90-day interest rate = 2%
U.K. 90-day interest rate = 4%
Borrow $ at 3%, or use existing funds which are earning interest at
2%. Convert $ to £ at $1.60/£ and engage in a 90-day forward
contract to sell £ at $1.60/£. Lend £ at 4%.
International Arbitrage
? Locational arbitrage ensures that quoted
exchange rates are similar across banks in
different locations.
? Triangular arbitrage ensures that cross exchange
rates are set properly.
? Covered interest arbitrage ensures that forward
exchange rates are set properly.
International Arbitrage
? Any discrepancy will trigger arbitrage, which
will then eliminate the discrepancy. Arbitrage
thus makes the foreign exchange market more
orderly.
International Arbitrage
Interest Rate Parity (IRP)
? Market forces cause the forward rate to differ
from the spot rate by an amount that is sufficient
to offset the interest rate differential between the
two currencies.
? Then, covered interest arbitrage is no longer
feasible, and the equilibrium state achieved is
referred to as interest rate parity (IRP).
Derivation of IRP
? When IRP exists, the rate of return achieved from
covered interest arbitrage should equal the rate of return
available in the home country.
? End-value of a $1 investment in covered interest
arbitrage = (1/S) × (1+i
F
) × F
= (1/S) × (1+i
F
) × [S × (1+p)]
= (1+i
F
) × (1+p)
where p is the forward premium.
Derivation of IRP
? End-value of a $1 investment in the home
country = 1 + i
H
? Equating the two and rearranging terms:
p =
(1+i
H
)
– 1
(1+i
F
)
i.e.
forward
=
(1 + home interest rate)
– 1
premium (1 + foreign interest rate)
Determining the Forward Premium
Example:
? Suppose 6-month i
peso
= 6%, i
$
= 5%.
? From the U.S. investor’s perspective,
forward premium = 1.05/1.06 – 1 ~ - .0094
? If S = $.10/peso, then
6-month forward rate = S × (1 + p)
~ .10 × (1
_
.0094)
~ $.09906/peso
Determining the Forward Premium
? Note that the IRP relationship can be rewritten as
follows:
F – S
=
S(1+p) – S
= p =
(1+i
H
)
– 1 =
(i
H
–i
F
)
S S (1+i
F
) (1+i
F
)
? The approximated form, p ~ i
H
–i
F
, provides a reasonable
estimate when the interest rate differential is small.
Graphic Analysis of Interest Rate Parity
Interest Rate Differential (%)
home interest rate – foreign interest rate
Forward
Premium (%)
Forward
Discount (%)
- 2
- 4
2
4
1 3 - 1 - 3
IRP line
Graphic Analysis of Interest Rate Parity
Interest Rate Differential (%)
home interest rate – foreign interest rate
Forward
Premium (%)
Forward
Discount (%)
- 2
- 4
2
4
1 3 - 1 - 3
IRP line
Zone of potential
covered interest
arbitrage by local
investors
Zone of potential
covered interest
arbitrage by foreign
investors
Test for the Existence of IRP
? To test whether IRP exists, collect the actual
interest rate differentials and forward premiums
for various currencies. Pair up data that occur at
the same point in time and that involve the same
currencies, and plot the points on a graph.
? IRP holds when covered interest arbitrage is not
worthwhile.
Interpretation of IRP
? When IRP exists, it does not mean that both
local and foreign investors will earn the same
returns.
? What it means is that investors cannot use
covered interest arbitrage to achieve higher
returns than those achievable in their respective
home countries.
Does IRP Hold?
? Various empirical studies indicate that IRP
generally holds.
? While there are deviations from IRP, they are
often not large enough to make covered interest
arbitrage worthwhile.
? This is due to the characteristics of foreign
investments, including transaction costs,
political risk, and differential tax laws.
Considerations When Assessing IRP
Transaction Costs
i
H
– i
F
p
Zone of potential
covered interest
arbitrage by foreign
investors
Zone of
potential
covered interest
arbitrage by
local investors
IRP line
Zone where covered
interest arbitrage is not
feasible due to transaction
costs
Impact of Arbitrage on an MNC’s Value
( ) ( ) | |
( )
¿
¿
¦
¦
)
¦
¦
`
¹
¦
¦
¹
¦
¦
´
¦
+
×
=
n
t
t
m
j
t j t j
k
1 =
1
, ,
1
ER E CF E
= Value
E (CF
j,t
) = expected cash flows in currency j to be received by
the U.S. parent at the end of period t
E (ER
j,t
) = expected exchange rate at which currency j can be
converted to dollars at the end of period t
k = weighted average cost of capital of the parent
Forces of Arbitrage
CHAPTER 8 : Relationships between
Exchange Rates, Inflation and Interest Rates
PPP
? Theory: The price of a commodity of basket should be same in both
the countries after taking into consideration the exchange rate
? Absolute Form:
? Example: Price of a Standard commodity Basket:
? In US: $ 225
? In UK: £ 150
? Exchange Rate: $225 = £150 ? $1.5 = £1 ? ER = $1.5/£
? S($/£) = P
$
÷P
£
? Relative Form:
? Example: Inflation levels
? US: 5%
? UK: 7%
? Change in Exchange Rate: (5 – 7) i.e. 2% depreciation in £
? e = t
$
- t
£
Derivation of PPP
Assume,
Home country’s price index (P
h
) = foreign country’s price index (P
f
)
? When inflation occurs, the exchange rate will adjust to maintain PPP:
P
f
(1 + I
f
) (1 + e
f
) = P
h
(1 + I
h
)
where I
h
= inflation rate in the home country
I
f
= inflation rate in the foreign country
e
f
= % change in the value of the foreign currency
? Since P
h
= P
f
, solving for e
f
gives:
e
f
=
(1 + I
h
)
– 1
(1 + I
f
)
If I
h
= 5% & I
f
= 3%, e
f
= 1.05/1.03 – 1 = 1.94%
¬ From the home country perspective, both price indexes rise by 5%.
? When the inflation differential is small, the PPP relationship can be simplified as
e
f
~ I
h
_
I
f
Graphical Analysis of PPP
Inflation Rate Differential (%)
home inflation rate – foreign inflation rate
% A in the
foreign
currency’s spot
rate
- 2
- 4
2
4
1 3 - 1 - 3
PPP line
Graphical Analysis of PPP
Inflation Rate Differential (%)
home inflation rate – foreign inflation rate
% A in the
foreign
currency’s spot
rate
- 2
- 4
2
4
1 3 - 1 - 3
PPP line
Increased
purchasing
power of
foreign
goods
Decreased
purchasing
power of
foreign
goods
Testing the PPP Theory
? Graphical:
? Plot the actual inflation differential and exchange rate % change for two or
more countries on a graph.
? Statistical Test:
? Apply regression analysis to the historical exchange rates and inflation
differentials:
e
f
= a
0
+ a
1
{ (1+I
h
)/(1+I
f
) - 1 } + µ
? Test for
? Ho: a
0
= 0
? Ho: a
1
= 1
? Empirical studies indicates PPP is not perfect even in the long run
i.e. Both the Ho are rejected (even in the long run)
? Limitation of PPP Tests:
? Base Period Effect
PPP Tests for Selected Currencies
Based on annual data for 1971-2000
-4
-2
0
2
4
6
8
10
-20 -10 0 10 20 30 40
-8
-6
-4
-2
0
2
4
-10 -8 -6 -4 -2 0 2 4 6 8 10
-20
-15
-10
-5
0
5
-20 -10 0 10 20
I
U.S.
– I
U.K.
-15
-10
-5
0
5
10
-20 -10 0 10 20 30 40 50
e
£
I
U.S.
– I
Canada
e
C$
I
U.S.
– I
Japan
e
¥
I
U.S.
– I
Germany
e
DEM
Deviations from PPP
? Confounding effects of many other variables:
? Differentials in interest rates
? Income levels
? Risk
? Government controls
? Non-tradable Goods like Hair cut v/s Tradable Goods like
Camera Film
? Haircuts cost 10 times as much in the developed world as in the
developing world.
? Film, on the other hand, is a highly standardized commodity that is
actively traded across borders.
? Shipping costs, as well as tariffs and quotas can lead to
deviations from PPP
PPP Deviations and the Real Exchange Rate
? The real exchange rate: Actual exchange rate adjusted for
inflationary effects in the two countries of concern
? If PPP holds, (1 + e) = (1 + t
$
)/(1 + t
£
), then q = 1.
? If q < 1 competitiveness of domestic country improves with
currency depreciations.
? If q > 1 competitiveness of domestic country deteriorates with
currency depreciations.
) 1 )( 1 (
1
£
$
t
t
+ +
+
=
e
q
Real Exchange Rates for different currencies
Quarterly
Growth Rates
of Real
Exchange
Rates
Alternative Theories
? Big Mac Index: Prices of McDonald’s Big Mac Burger
in different countries
? Suggests $1 PPP of ¥169 and DM2.07
? Fundamental Equilibrium Exchange Rate(FEER)
? Rate that will generate current a/c deficit(surplus) equal to the
capital inflow(outflow)
? Strong correlation between a currency’s under or over-
valuation against dollar relative to its Big Mac, PPP and
Country’s Current A/c Deficit
International Fisher Effect (IFE)
Theory: According to the Fisher effect, nominal risk-
free interest rates contain a real rate of return and
an anticipated inflation
•An increase (decrease) in the expected rate of
inflation will cause a proportionate increase
(decrease) in the interest rate in the country
For the U.S., the Fisher effect is written as:
i
$
= µ
$
+ E(t
$
)
Where
µ
$
is the equilibrium expected “real” U.S. interest rate
E(t
$
) is the expected rate of U.S. inflation
i
$
is the equilibrium expected nominal U.S. interest rate
? The international Fisher effect (IFE) theory suggests
that currencies with higher interest rates will
depreciate because the higher rates reflect higher
expected inflation.
? Hence, investors hoping to capitalize on a higher
foreign interest rate should earn a return no better
than what they would have earned domestically.
Derivation
? The IFE states that
? The return on investment in Foreign Market should be
equal to the return on investment in Domestic Market
? Real Rate of Interests are equal
If the Fisher effect holds in the U.S.
i
$
= µ
$
+ E(t
$
)
and the Fisher effect holds in Japan,
i
¥
= µ
¥
+ E(t
¥
)
and if the real rates are the same in each country
µ
$
= µ
¥
then we get the International Fisher Effect
E(e) = i
$
- i
¥
.
? Also,
? r
f
= (1 + i
f
) (1 + e
f
) – 1
i
f
= interest rate in the foreign country
e
f
= % change in the foreign currency’s
value
? Setting r
f
= r
h
: (1 + i
f
) (1 + e
f
) – 1 = i
h
? Solving for e
f
:
e
f
=
(1 + i
h
) _
1
(1 + i
f
)
¬ If i
h
> i
f
, e
f
> 0 (foreign currency appreciates)
If i
h
< i
f
, e
f
< 0 (foreign currency depreciates)
If i
h
= 8% & i
f
= 9%, e
f
= 1.08/1.09 – 1 = - .92%
¬This will make the return on the foreign investment equal
to the domestic return
Example
? If the British rate on 6-month deposits were 2%
above the U.S. interest rate, the £ should
depreciate by approximately 2% over 6 months.
Then U.S. investors would earn about the same
return on British deposits as they would on U.S.
deposits.
Graphic Analysis of the International Fisher
Effect
Interest Rate Differential (%)
home interest rate – foreign interest rate
- 2
- 4
2
4
1 3 - 1 - 3
IFE line
% A in the
foreign
currency’s
spot rate
Higher returns
from investing
in foreign
deposits
Lower returns
from investing
in foreign
deposits
Graphic Analysis of the IFE
? The point of the IFE theory is that if a firm
periodically tries to capitalize on higher foreign
interest rates, it will achieve a yield that is
sometimes above and sometimes below the
domestic yield
? On the average, the firm would achieve a yield
similar to that by a corporation that makes
domestic deposits only
Why the IFE Does Not Occur
• Since the IFE is based on PPP, it will
not hold when PPP does not hold.
• For example, if there are factors other
than inflation that affect exchange rates,
the rates will not adjust in accordance
with the inflation differential.
Equilibrium Exchange Rate Relationships
S
(F - S)
E(e)
) -i (i
¥ $
t
$
- t
£
IR
P
PPP
FE FRPP
P
IFE FP
Chapter 9: Forecasting Exchange Rates
Chapter Objectives
? To explain how firms can benefit from
forecasting exchange rates;
? To describe the common techniques used for
forecasting; and
? To explain how forecasting performance can be
evaluated.
? MNCs need exchange rate forecasts for their:
? hedging decisions,
? short-term financing decisions,
? short-term investment decisions,
? capital budgeting decisions,
? long-term financing decisions, and
? earnings assessment.
Why Firms Forecast
Exchange Rates
Forecasting Techniques
? The numerous methods available for forecasting
exchange rates can be categorized into four
general groups:
? technical,
? fundamental,
? market-based,and
? mixed.
? Technical forecasting involves the use of
historical data to predict future values. It
includes statistical analysis and time series
models.
? Speculators may find the models useful for
predicting day-to-day movements.
? However, since they typically focus on the near
future and rarely provide point/range estimates,
they are of limited use to MNCs.
Technical Forecasting
? Technical analysis looks for patterns in the past
behavior of exchange rates.
? Clearly it is based upon the premise that history
repeats itself.
? Thus it is at odds with the EMH
Technical Forecasting
Technical Forecasting Example
Tomorrow Kansas Co. has to pay 10 million Mexican pesos for supplies that it
recently from Mexico. Today, the peso has appreciated by 3 percent against the
dollar. Kansas Co. could send the payment today so that it would avoid the effects
of any additional appreciation tomorrow. Based on an analysis of historical time
series, Kansas has determined that whenever the peso appreciates against the dollar
by more than 1 percent, it experiences a reversal of about 60 percent on the
following day. That is,
e
t+1
= e
t
x (- 60%) when e
t
> 1%
Applying this tendency to the current situation in which the peso appreciated by 3
percent today, Kansas Co. forecasts that tomorrow’s exchange rate will change by
e
t+1
= e
t
x (- 60%)
= (3%) x (- 60%)
= - 1.8%
? Fundamental forecasting is based on the
fundamental relationships between economic
variables and exchange rates.
? A forecast may arise simply from a subjective
assessment of the factors that affect exchange
rates.
? A forecast may be based on quantitative
measurements (with the aid of regression
models and sensitivity analysis) too.
Fundamental Forecasting
Fundamental Forecasting
Involves econometrics to develop models that
use a variety of explanatory variables. This
involves three steps:
step 1: Estimate the structural model.
step 2: Estimate future parameter values.
step 3: Use the model to develop forecasts.
The downside is that fundamental models do
not work any better than the forward rate model
or the random walk model.
Fundamental Forecasting Example -
Regression
Objective : forecast the percentage change in the British
pound with respect to the US dollar during the next quarter.
Assume the forecast is dependent only two factors that
affect the pound’s value: relative inflation, relative income
growth
The regression equation can be defined as:
BP
t
= b
0
+ b
1
INF
t-1
+ b
2
INC
t-1
+ µ
t
Assume b
0
= .002, b
1
= .8 and b
2
= 1.0, INF
t-1
= 4%, INC
t-1
= 2%
BP
t
= .002 + .8(4%) + 1(2%)
= 5.4%
Fundamental Forecasting Example –
Sensitivity Analysis
e
t
= a
0
+ a
1
INT
t
+ a
2
INF
t-1
+ µ
t
Assume a
0
= .001, a
1
= - .7, a
2
= .6
Assume that Phoenix Corp. has developed the following probability
distribution for INT
t
Probability Possible
Outcome
20% -3%
50% -4%
30% -5%
A separate forecast of e
t
can be developed from each possible
outcome of INT
t
as follows:
Forecast of INT Forecast of e
t
Probability
-3% .1% + (-.7)(-3%) + .6(1%) = 2.8% 20%
-4% .1% + (-.7)(-4%) + .6(1%) = 3.5% 50%
-5% .1% + (-.7)(-5%) + .6(1%) = 4.2% 30%
Fundamental Forecasting Example – Use of
PPP
According to PPP, the currency of the relatively inflated country will depreciate
by an amount that reflects that country’s inflation differential.
Example: The US inflation rate is expected to be 1 percent over the next year,
while the Australian inflation rate is expected to be 6 percent. According to
PPP, the Australian dollar’s exchange rate should change as follows:
e
f
= (1 + I
US
) - 1
(1 + I
f
)
= 1.01 - 1
1.06
= -4.7%
E(S
t
+1) = S
t
(1+e
f
)
= $.50 [ 1 + (-.047)]
= $.4765
? Known relationships like the PPP can be used
for the regression models. However, problems
may arise. In the case of PPP:
? the timing of the impact of inflation on trade behavior
is not known for sure,
? prices may be measured inaccurately,
? trade barriers may disrupt the trade patterns that
should emerge, and
? other influential factors may exist.
Fundamental Forecasting
? In general, fundamental forecasting is limited by :
? the uncertain timing of the impact of the factors,
? the need for forecasts for factors with instantaneous
impact,
? the possibility that other relevant factors may be omitted
from the model, and
? changes in the sensitivity of currency movements to
each factor over time.
Fundamental Forecasting
? Market-based forecasting involves developing
forecasts from market indicators.
? Usually, either the spot rate or the forward rate
is used, since speculation should push the rates
to the level that reflect the market expectation of
the future exchange rate.
Market-Based Forecasting
Market-Based Forecasting: Example
? If the one year forward rate of the Australian
dollar is $0.63, while the spot rate is $0.60, the
expected percentage change in the Australian
dollar is
? E(e) = p
= (F/S)-1
=(0.63/0.60)-1
=0.05, or 5%
? Since forward contracts have low trading
volumes and are not widely quoted, the interest
rates on risk-free instruments can be used to
determine what the forward rates should be
according to IRP for long-term forecasting.
Market-Based Forecasting
Mixed Forecasting
? Mixed forecasting refers to the use of a
combination of forecasting techniques.
? The actual forecast is a weighted average of the
various forecasts developed.
Forecasting Services
? The corporate need to forecast currency values
has prompted some consulting firms and
investment banks to offer forecasting services.
? Advice on hedging and international cash
management, and assessment of the firm’s
exposure to exchange rate risk, may be provided
too.
? One way to determine whether a forecasting
service is valuable is to compare the accuracy of
its forecasts with the accuracy of publicly
available and free forecasts.
Forecasting Services
Evaluation of Forecast Performance
? An MNC that forecasts exchange rates should
monitor its performance over time to determine
whether its forecasting procedure is satisfactory.
? The MNC may also want to compare the various
forecasting methods.
Evaluation of Forecast Performance
? One measure of forecast performance is the
absolute forecast error as a percentage of the
realized value:
| forecasted value – realized value |
realized value
? Over time, MNCs are likely to have more
confidence in their forecasts when they know
the mean error for their past forecasts.
Evaluation of Forecast Performance
Using the Forward Rate as a Forecast for the British Pound
0.00
0.05
0.10
0.15
0.20
0.25
0.30
0.35
1975 1980 1985 1990 1995 2000
A
b
s
o
l
u
t
e
F
o
r
e
c
a
s
t
E
r
r
o
r
(
$
)
Evaluation of Forecast Performance
? The ability to forecast currency values may vary
with the currency of concern.
? In particular, the value of a less volatile currency
is likely to be forecasted more accurately.
Mean Absolute Forecast Error
Currency as a Percent of the Realized Value
1974-1998 1974-1984 1985-1998
British pound 4.61 % 5.06 % 4.21
%
Canadian dollar 1.73 1.70 1.75
Japanese yen 5.60 5.22 5.93
Swiss franc 5.69 5.81 5.58
Evaluation of Forecast Performance
Forecast Bias
? If the forecast errors are consistently positive or
negative over time, then there is a bias in the
forecasting procedure.
Forecast Bias
Using the Forward Rate as a Forecast for the British Pound
$1.00
$1.20
$1.40
$1.60
$1.80
$2.00
$2.20
$2.40
$2.60
1975 1980 1985 1990 1995 2000
Forward Rate
Realized
Spot Rate
Forecast Bias
? The following regression model can be used to
test for forecast bias:
realized = a
0
+ a
1
´ forecast + µ
? If a predictor is found to be biased, the estimated
a
0
and a
1
values can be used to correct the
systematic error.
Graphic Evaluation of Forecast Performance
Perfect
forecast line
x z
x
z
R
e
a
l
i
z
e
d
V
a
l
u
e
Predicted Value
Region of downward bias
(underestimating)
Region of
upward bias
(overestimating)
Graphic Evaluation of Forecast Performance
Using the Forward Rate as a Forecast for the British Pound
R
e
a
l
i
z
e
d
S
p
o
t
R
a
t
e
$1.00
$1.50
$2.00
$2.50
$1.00 $1.50 $2.00 $2.50
Forecast (Forward Rate)
Perfect
Forecast
Line
Graphic Evaluation
of Forecast Performance
? If the points appear to be scattered evenly on
both sides of the perfect forecast line, then the
forecasts are said to be unbiased.
? Note that a more thorough assessment can be
conducted by separating the entire period into
subperiods.
Comparison of
Forecasting Techniques
? The different forecasting techniques can be
evaluated
? graphically - by comparing the distances from the
perfect forecast line, or
? statistically - by computing the mean of the absolute
forecast errors, and then using a t-test or a
nonparametric test to determine whether there is a
significant difference in the accuracy of the
forecasting techniques.
Efficient Markets Approach
Financial Markets are efficient if prices
reflect all available and relevant information.
If this is so, exchange rates will only change
when new information arrives, thus:
S
t
= E[S
t+1
]
and
F
t
= E[S
t+1
| I
t
]
Predicting exchange rates using the
efficient markets approach is affordable and
is hard to beat.
Forecasting Under Market Efficiency
? If the foreign exchange market is weak-form
efficient, then the current exchange rates already
reflect historical information. So, technical
analysis would not be useful.
? If the market is semistrong-form efficient, then
all the relevant public information is already
reflected in the current exchange rates.
? If the market is strong-form efficient, then all the
relevant public and private information is
already reflected in the current exchange rates.
? Foreign exchange markets are generally found
to be at least semistrong-form efficient.
Forecasting Under Market Efficiency
? Nevertheless, MNCs may still find forecasting
worthwhile, since their goal is not to earn
speculative profits but to use exchange rate
forecasts to implement policies.
? In particular, MNCs may need to determine the
range of possible exchange rates in order to
assess the degree to which their operating
performance could be affected.
Forecasting Under Market Efficiency
Exchange Rate Volatility
? MNCs also forecast exchange rate volatility.
This enables them to specify a range
(confidence interval) and develop best-case and
worst-case scenarios along with their point
estimate forecasts.
? Popular methods for forecasting volatility
include:
? the use of recent exchange rate volatility,
Exchange Rate Volatility
? the use of a historical time series of volatilities (there
may be a pattern in how the exchange rate volatility
changes over time), and
? the derivation of the exchange rate’s implied
standard deviation from the currency option pricing
model.
Exchange Rate Volatility-Example
? Harp, Inc. an MNC imports products from Canada.
Current spot rate of Canadian $ is 0.70. Harp determines
the S.D. of Canadian $ over the last 12 months is 2%.
? Thus assuming the movements are normally distributed,
it expects that there is a 68% chance that the actual value
will be in a range from $0.686 to $0.714(1 S.D.) and
there is a 95% chance that the actual value will be in a
range from $0.672 to $0.728(2 S.D)
Application of Exchange Rate Forecasting
to the Asian Crisis
? Before the crisis, the spot rate served as a
reasonable predictor, because the central banks
were maintaining a somewhat stable value for
their respective currencies.
? But even after the crisis began, it is unlikely that
the degree of depreciation could have been
accurately predicted by the usual models.
Application of Exchange Rate Forecasting
to the Asian Crisis
? The large amount of foreign investment and the
fear of a massive selloff of the currencies played
key roles in the sharp decline of the Asian
currency values.
? However, these two factors cannot be easily
incorporated into a fundamental forecasting
model in a manner that will precisely identify
the timing and magnitude of currency
depreciation.
Impact of Forecasted Exchange Rates
on an MNC’s Value
( ) ( ) | |
( )
¿
¿
¦
¦
)
¦
¦
`
¹
¦
¦
¹
¦
¦
´
¦
+
×
=
n
t
t
m
j
t j t j
k
1 =
1
, ,
1
ER E CF E
= Value
E (CF
j,t
) = expected cash flows in currency j to be received by
the U.S. parent at the end of period t
E (ER
j,t
) = expected exchange rate at which currency j can be
converted to dollars at the end of period t
k = weighted average cost of capital of the parent
Technical Forecasting
Fundamental Forecasting
Market-based Forecasting
Mixed Forecasting
? Why Firms Forecast Exchange Rates
? Forecasting Techniques
? Technical Forecasting
? Fundamental Forecasting
? Market-Based Forecasting
? Mixed Forecasting
? Forecasting Services
? Performance of Forecasting Services
Chapter Review
Chapter Review
? Evaluation of Forecast Performance
? Forecast Accuracy Over Time
? Forecast Accuracy Among Currencies
? Search for Forecast Bias
? Statistical Test of Forecast Bias
? Graphic Evaluation of Forecast Performance
? Comparison of Forecasting Techniques
Chapter Review
? Forecasting Under Market Efficiency
? Exchange Rate Volatility
? Application of Exchange Rate Forecasting to the
Asian Crisis
? How Exchange Rate Forecasting Affects an
MNC’s Value
doc_828243773.pptx