INTERNATIONAL PARITY CONDITIONS

MODULE 4B FOREIGN EXCHANGE RATE DETERMINATION AND

INTERVENTION

1
EXCHANGE RATE DETERMINATION (1 OF
2)

 Exchange rate determination is complex.

 Exhibit 9.1 provides an overview of the many determinants of

exchange rates.

 This road map is first organized by the three major schools of

thought (parity conditions approach, balance of payments
approach, monetary and asset market approaches), and
secondly by the individual drivers within those approaches.

 These are not competing theories but rather complementary

theories.
EXHIBIT 9.1 The Determinants of Foreign Exchange Rates
EXCHANGE RATE DETERMINATION (2 OF
2)

 Two other institutional dimensions are considered—whether the

country possesses the capital markets and banking systems
needed to drive and discover value.

 Most determinants of the spot exchange rate are mutually

determined by changes in the spot rate.
PARITY CONDITIONS APPROACH

 The theory of purchasing power parity is the most widely

accepted theory of all exchange rate determination theories:
 PPP is the oldest and most widely followed of the exchange rate
theories.
 Most exchange rate determination theories have PPP elements
embedded within their frameworks.
 PPP calculations and forecasts are, however, plagued with structural
differences across countries and significant data challenges in
estimation.
FROM MODULE 4A (CONTINUED)

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INTEREST RATE PARITY (IRP)

 The theory of Interest Rate Parity (IRP) provides the linkage

between the foreign exchange markets and the international
money markets.
 The theory states, “The difference in the national interest rates for
securities of similar risk and maturity should be equal to, but
opposite in sign to, the forward rate discount or premium for the
foreign currency, except for transaction costs.”
 See Exhibit 6.5
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EXHIBIT 6.5
Interest Rate Parity (IRP)

For long description, see slide 44: Appendix 5

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COVERED INTEREST ARBITRAGE (CIA)

 The spot and forward exchange rates are not constantly in the state of
equilibrium described by interest rate parity.
 When the market is not in equilibrium, the potential for “risk-less” or
arbitrage profit exists.
 The arbitrager will exploit the imbalance by investing in whichever
currency offers the higher return on a covered basis.
 See Exhibit 6.6
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EXHIBIT 6.6
Covered Interest Arbitrage (CIA)

For long description, see slide 45: Appendix 6

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UNCOVERED INTEREST ARBITRAGE (UIA)

 In the case of uncovered interest arbitrage (UIA), investors borrow in

countries and currencies exhibiting relatively low interest rates and convert
the proceed into currencies that offer much higher interest rates.
 The transaction is “uncovered” because the investor does not sell the
higher yielding currency proceeds forward, choosing to remain uncovered
and accept the currency risk of exchanging the higher yield currency into
the lower yielding currency at the end of the period.
 See Exhibit 6.7
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EXHIBIT 6.7 Uncovered Interest Arbitrage (UIA): The Yen Carry Trade

For long description, see slide 46: Appendix 7

PRICES, INTEREST RATES, AND
EXCHANGE RATES IN EQUILIBRIUM

 Exhibit 6.10 illustrates all of the fundamental parity relations

simultaneously, in equilibrium, using the U.S. dollar and the
Japanese yen.

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EXHIBIT 6.10
International Parity Conditions in Equilibrium (in approximate form)

For long description, see slide 49: Appendix 10

BALANCE OF PAYMENTS APPROACH

 The balance of payments approach is the second most utilized

theoretical approach in exchange rate determination:
 The basic approach argues that the equilibrium exchange rate is
found when currency flows match up vis-à-vis current and financial
account activities.
 This framework has wide appeal as BOP transaction data is readily
available and widely reported.
 Critics may argue that this theory does not take into account stocks of
money or financial assets.
MONETARY APPROACH AND ASSET
MARKET APPROACH (1 OF 5)

 The monetary approach in its simplest form states that the

exchange rate is determined by the supply and demand for
national monetary stocks, as well as the expected future levels
and rates of growth of monetary stocks.

 Other financial assets, such as bonds, are not considered

relevant for exchange rate determination, as both domestic and
foreign bonds are viewed as perfect substitutes.
MONETARY APPROACH AND ASSET
MARKET APPROACH (2 OF 5)

 The asset market approach argues that exchange rates are

determined by the supply and demand for a wide variety of
financial assets:
 Shifts in the supply and demand for financial assets alter exchange
rates.
 Changes in monetary and fiscal policy alter expected returns and
perceived relative risks of financial assets, which in turn alter
exchange rates.
MONETARY APPROACH AND ASSET
MARKET APPROACH (3 OF 5)

 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.
MONETARY APPROACH AND ASSET
MARKET APPROACH (4 OF 5)

 Foreign investors are willing to hold securities and undertake

foreign direct investment in highly developed countries based
primarily on relative real interest rates and the outlook for
economic growth and profitability.
MONETARY APPROACH AND ASSET
MARKET APPROACH (5 OF 5)
 The asset market approach assumes that whether foreigners are
willing to hold claims in monetary form depends on an
extensive set of investment considerations or drivers (among
others):
 Relative real interest rates
 Prospects for economic growth
 Capital market liquidity
 A country’s economic and social infrastructure
 Political instability
 Corporate governance laws and practices
 Contagion (spread of a crisis within a region)
 Speculation
  Foreign currency intervention is the active management,

CURRENCY manipulation, or intervention in the market’s valuation of a country’s

currency.
MARKET  Why Intervene?
INTERVENTION  Fight inflation (strong currency)
 Fight slow economic growth (weak currency)
INTERVENTION METHODS (1 OF 3)

 Methods of intervention are determined by magnitude of a

country’s economy, magnitude of trading in its currency, and
the country’s financial market development.

 Direct Intervention
 The active buying and selling of the domestic currency against
foreign currencies.
 If the goal is to increase the value, then the central bank buys its own
currency.
 If the goal is to decrease the value, then the central bank sells its own
currency.
INTERVENTION METHODS (2 OF 3)

 If bank intervention is insufficient, then coordinated intervention

may be used whereby several central banks agree on a strategy
to increase or decrease a currency value.

 Indirect Intervention
 The alteration of economic or financial fundamentals which are
thought to be drivers of capital to flow in and out of specific
currencies.
 Increase real rates to strengthen a currency.
 Decrease real rates to weaken a currency.
INTERVENTION METHODS (3 OF 3)

 Capital controls are restrictions of access to foreign currency by

the government by limiting the exchange of domestic currency
for foreign currency.

 Although intervention may fail, understanding the motivations

and methods for currency market intervention is critical to any
analysis of the determination of future exchange rates.
WHEN FOREIGN CURRENCY
INTERVENTION FAILS

 It is important to remember that intervention may—and often

does—fail.
 Turkish currency crisis of 2014 is a classic example of a drastic
indirect intervention that ultimately only slowed the rate of capital
flight and currency collapse.
 The Bank of Japan intervened in the foreign exchange markets in
2010 in an attempt to slow the appreciating yen by buying U.S.
dollars. However, the intervention was largely unsuccessful.
  Although the three different schools of thought on exchange rate
determination make understanding exchange rates appear to be
straightforward, that it rarely the case.
DISEQUILIBRIUM:  The large and liquid capital and currency markets follow many of
EXCHANGE RATES IN the principles outlined so far relatively well in the medium to long

EMERGING MARKETS term, but the smaller and less liquid markets frequently
demonstrate behaviors that seemingly contradict the theory.

 The problem lies not in the theory, but in the relevance of the
assumptions underlying the theory.
THE ASIAN CRISIS OF 1997 (1 OF 3)

 The roots of the Asian currency crisis extended from a fundamental

change in the economics of the region, the transition of many Asian
nations from being net exporters to net importers.

 The most visible roots of the crisis were the excess capital inflows into
Thailand in 1996 and early 1997.

 As the investment “bubble” expanded, some market participants

questioned the ability of the economy to repay the rising amount of
debt and the Thai bhat came under attack.
THE ASIAN CRISIS OF 1997 (2 OF 3)

 The Thai government intervened directly (using up precious hard

currency reserves) and indirectly by raising interest rates in support of
the currency.

 Soon thereafter, the Thai investment markets ground to a halt and the
Thai central bank allowed the bhat to float.

 The bhat fell dramatically (see Exhibit 9.4) and soon other Asian
currencies (Philippine peso, Malaysian ringgit, and the Indonesian
rupiah) came under speculative attack.
EXHIBIT 9.4 The Thai Baht and the Asian Crisis
THE ASIAN CRISIS OF 1997 (3 OF 3)

 The Asian economic crisis (which was much more than just a currency
collapse) had many roots besides traditional balance of payments
difficulties:
 Corporate socialism
 Corporate governance cronyism
 Banking instability

 What started as a currency crisis became a region-wide recession.

 Other countries blamed the international financier George Soros for

causing the crisis with his political agenda.
  In 1991, the Argentine peso had been fixed to the U.S. dollar at a
THE ARGENTINE one-to-one rate of exchange.
CRISIS OF 2002 (1  A currency board structure was implemented in an effort to eliminate
OF 3) the source inflation that had devastated the nation’s standard of
living in the past.
  By 2001, after three years of recession, three important problems

THE ARGENTINE with the Argentine economy became apparent:

CRISIS OF 2002 (2 


The Argentine peso was overvalued.
The currency board regime had eliminated monetary policy alternatives for
OF 3) macroeconomic policy.
 The Argentine government budget deficit—and deficit spending—was out
of control.
  In January 2002, the peso was devalued as a result of enormous
social pressures resulting from deteriorating economic conditions
and substantial runs on banks.
THE ARGENTINE  However, the economic pain continued and the banking system
CRISIS OF 2002 (3 remained insolvent.

OF 3)  Social unrest continued as the economic and political systems within

the country collapsed; certain government actions set the stage for a
constitutional crisis.

 Exhibit 9.5 tracks the decline of the Argentine peso.

EXHIBIT 9.5 The Collapse of the Argentine Peso
CURRENCY FORECASTING IN PRACTICE

 Exhibit 9.6 summarizes the various forecasting periods, regimes,

and most widely followed methodologies.

 Whether any of the forecasting services are worth their cost

depends both on the motive for forecasting as well as the
required accuracy.

 The longer the time horizon of the forecast, the more inaccurate,
but also the less critical the forecast is likely to be.

 Accuracy of short-term forecasts is critical, since most of the

exchange rate changes are relatively small even though the day-
to-day volatility may be high.
Forecast Period Regime Recommended Forecast Methods

Short Run Fixed-Rate 1. Assume the fixed-rate is maintained

EXHIBIT 9.6
2. Are there indications of stress on the fixed-rate?
3. Are there capital controls or black market exchanges? 4
4. Are there indicators of government’s capability to maintain the fixed-

EXCHANGE RATE
rate?
5. Are there changes in foreign currency reserves?

Floating-Rate
1. Technical methods which capture trend
2. Forward rates as forecasts (< 30 days assume random walk; 30-90
days use forward)
FORECASTING IN
3. For periods of 90-360 days combine trend with fundamental analysis
4. Fundamental analysis of inflationary concerns
5. Government declarations and agreements regarding exchange rate
PRACTICE
goals
6. Cooperative agreements with other countries

Long Run Fixed-Rate 1. Fundamental analysis

2. Balance of payments management
3. Ability to control domestic inflation
4. Ability to generate hard currency reserves to use for intervention
purposes
5. Ability to run trade account surpluses

Floating-Rate 1. Focus on inflationary fundamentals and purchasing power parity

2. Indicators of general economic health such as economic growth and
stability
3. Technical analysis of long-term trends (possibility of long-term technical
‘waves’)
4. Government positions on relative international competitiveness and
boundaries
TECHNICAL ANALYSIS (1 OF 2)

 Technical analysts, traditionally referred to as chartists, focus on price

and volume data to determine past trends that are expected to
continue into the future.

 The single most important element of technical analysis is that future

exchange rates are based on the current exchange rate.

 Exchange rate movements can be subdivided into three periods:

 Day-to-day
 Short-term (several days to several months)
 Long-term
TECHNICAL ANALYSIS (2 OF 2)

 Many of the forecast needs of the firm are short to medium term in
their time horizon and can be addressed with less theoretical
approaches.

 These technical analyses based on time—time series techniques—infer

no theory or causality but simply predict future values from the recent
past.

 Forecasters freely mix fundamental theories and technical analysis

because forecasting is about just getting close.
  International financial managers forecast their home currency
exchange rates for a variety of reasons including:
CROSS-RATE  Decide whether to hedge

CONSISTENCY IN  Decide whether to make investments

FORECASTING  To prepare multi-country operating budgets in the home country’s

currency

 Checking cross-rate consistency assesses the reasonableness of the

cross-rate implicit in individual forecasts.
FORECASTING: WHAT TO THINK? (1 OF 2)

 It appears, from decades of theoretical and empirical studies, that

exchange rates do adhere to the fundamental principles and theories
previously outlined.

 Fundamentals do apply in the long term

 There is, therefore, something of a fundamental equilibrium path for a

currency’s value.
FORECASTING: WHAT TO THINK? (2 OF 2)

 It also seems that in the short term, a variety of random events,

institutional frictions, and technical factors may cause currency values
to deviate significantly from their long-term fundamental path.

 This behavior is sometimes referred to as noise.

 Therefore, we might expect deviations from the long-term path not

only to occur, but to occur with some regularity and relative longevity.
Summary

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Summary

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Summary

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Appendix

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APPENDIX 5
Long Description for Exhibit 6.5

A diagram demonstrates how the same US dollar amount can generate very similar final amounts when it passes
through the US dollar money market and the Swiss franc money market over a 90-day period. The following list
outlines the conversion process in each market and compares the final amounts. With a start of 1,000,000 dollars
enters the U. S. dollar money market and the Swiss franc money market. The U.S. dollar money market uses the
euro dollar interest rate of 8.00 percent, which is equivalent to 2 percent for 90 days. 1,000,000 dollar times 1.02
equals 1,020,000 dollars. Before entering the Swiss franc money market, the starting amount is converted using
the spot exchange rate of SF 1.4800 equals 1.00 dollar. 1,000,000 dollar times 1.4800 equals SF 1,480,000. The
Swiss franc money market uses the Swiss franc interest rate of 4.00 percent per annum, which is equivalent to 1
percent for 90 days. SF 1,480,000 times 1.01 equals SF 1,494,800. This Swiss franc amount is then converted using
the 90-day forward rate, or F 90, of SF 1.4655 equals 1.00 dollar. SF 1,494,800 divided by 1.4655 equals 1,019,993
dollar. At the end, the final amount from the US dollar money market is 1,020,000 dollars. The final amount from
the Swiss franc money market is 1,019,993 dollars. The amounts only differ by a transaction cost of 7.00 dollars.

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APPENDIX 6
Long Description for Exhibit 6.6

A diagram demonstrates how the same U.S. dollar amount can generate different final amounts when it
passes through the U.S. dollar money market and the Japanese money market over a 180-day period. The
following list outlines the conversion process in each market and compares the final amounts. With a start
of 1,000,000-dollar entry the U.S. dollar money market and the Japanese yen money market. The U.S. dollar
money market uses the euro dollar interest rate of 8.00 percent, which is equivalent to 4 percent for 180
days. 1,000,000 dollar times 1.04 equals 1,040,000 dollars. Before entering the Japanese yen money market,
the starting amount is converted using the spot exchange rate 106.00 yen equals 1.00 dollar. 1,000,000
dollar times 106 equals S F 106,000,000 yen. For the Japanese yen money market, the investor uses a euro
yen account with an interest rate of 4.00 percent per annum, which is equivalent to 2 percent for 180 days.
106,000,000 yen times 1.02 equals 108,120,000 yen. This yen amount is then converted using the 180-day
forward rate, or F 180, of 103.50 yen equals 1.00 dollar. S F 108,120,000 yen divided by 103.50 equals
1,044,638 dollars.

End. The final amount from the US dollar money market is $1,040,000. The final amount from the Japanese
yen money market is $1,044,638. The amounts only differ by an arbitrage potential of $44,638.

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APPENDIX 7
Long Description for Exhibit 6.7

A diagram demonstrates how the same Japanese yen amount can generate different final amounts when it passes through
the Japanese yen money market and the U S dollar money market over a 360-day period. The following list outlines the
conversion process in each market and compares the final amounts. With a start of 10,000,000-yen entry the Japanese yen
money market and the U. S. dollar money market. For the Japanese yen money market, the investor borrows yen for 360
days at 0.40 percent per annum. 10,000,000 yen times 1.004 equals 10,040,000. Before entering the U. S. dollar money
market, the starting amount is converted using the spot exchange rate of 120.00 yen equals 1.00 dollar. 10,000,000 yen
divided by 120.00 equals 83,333.33 dollars. The investor deposits this amount in the U. S. dollar money market at 5.00
percent per annum. 83,333.33 dollar times 1.05 equals 87,500.00 dollars. The investor then converts this dollar amount back
to yen, using the expected spot exchange rate of 120.00 yen equals 1.00 dollar. 87,500.00 dollar times 120.00 equals
10,500,000 yen. At the end the final amount from the Japanese yen money market is 10,040,000, which is repaid. The final
amount from the U. S. dollar money market is 10,500,000, which is earned. The amounts differ by a profit of 4460,000 yen.

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APPENDIX 10
Long Description for Exhibit 6.10

The approximate model of equilibrium involves five relations identified by the letters A, B, C, D, and E. The
following list describes each relation based on changes to exchange rates, interest rates, and inflation for the
Japanese yen. Relation A: purchasing power parity. The forecast change in the spot exchange rate is plus 4
percent, meaning the yen strengthens. The forecast difference in rates of inflation is minus 4 percent, meaning less
in Japan. Relation B: Fisher effect. The forecast difference in rates on inflation is minus 4 percent, meaning less in
Japan. The difference in nominal interest rates is minus 4 percent, meaning less in Japan. Relation C: International
Fisher effect. The forecast change in the spot exchange rate is plus 4 percent, meaning the yen strengthens. The
difference in nominal interest rates is minus 4 percent, meaning less in Japan. Relation D: Interest rate. The
difference in nominal interest rates is minus 4 percent, meaning less in Japan. The forward premium on foreign
currency is plus 4 percent, meaning the yen strengthens. Relation E: forward rate as an unbiased predictor. The
forward premium on foreign currency is plus 4 percent, meaning the yen strengthens. The forecast change in the
spot exchange rate is plus 4 percent, meaning the yen strengthens.

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End of Module
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