Although it is easy to measure the percentage change in the value of a currency, it is more difficult to explain why the value changed or to forecast how it may change in the future. To achieve either of these objectives, the concept of an equilibrium exchange rate must be understood, as well as the factors that affect the equilibrium rate.
Before considering why an exchange rate changes, realize that an exchange rate at a given point in time represents the price of a currency, or the rate at which one currency can be exchanged for another. While the exchange rate always involves two currencies, our focus is from the U.S. perspective. Thus, the exchange rate of any currency refers to the rate at which it can be exchanged for U.S. dollars, unless specified otherwise. Like any other product sold in markets, the price of a currency is determined by the demand for that currency relative to supply. Thus, for each possible price of a British pound, there is a corresponding demand for pounds and a corresponding supply of pounds for sale. At any point in time, a currency should exhibit the price at which the demand for that currency is equal to supply, and this represents the equilibrium exchange rate. Of course, conditions can change over time, causing the supply or demand for a given currency to adjust, and thereby causing movement in the currency‘s price.
This topic is more thoroughly discussed in this section.
Demand for a Currency
The British pound is used here to explain exchange rate equilibrium. The United Kingdom has not adopted the euro as its currency and continues to use the pound. Exhibit 4.2 shows a hypothetical number of pounds that would be demanded under various possibilities for the exchange rate. At any one point in time, there is only one exchange rate. The exhibit shows the quantity of pounds that would be demanded at various exchange rates at a specific point in time. The demand schedule is downward sloping because corporations and individuals in the United States will be encouraged to purchase more British goods when the pound is worth less, as it will take fewer dollars to obtain the desired amount of pounds. Conversely, if the pound‘s exchange rate is high, corporations and individuals in the United States are less willing to purchase British goods, as they may obtain goods at a lower price in the United States or other countries.
Supply of a Currency for Sale
Up to this point, only the U.S. demand for pounds has been considered, but the British demand for U.S. dollars must also be considered. This can be referred to as a British supply of pounds for sale, since pounds are supplied in the foreign exchange market in exchange for U.S. dollars. A supply schedule of pounds for sale in the foreign exchange market can be developed in a manner similar to the demand schedule for pounds. Exhibit 4.3 shows the quantity of pounds for sale (supplied to the foreign exchange market in exchange for dollars) corresponding to each possible exchange rate at a given point in time. Notice from the supply schedule in Exhibit 4.3 that there is a positive relationship between the value of the British pound and the quantity of British pounds for sale (supplied), which can be explained as follows. When the pound is valued high, British consumers and firms are more likely to purchase U.S. goods. Thus, they supply a greater number of pounds to the market, to be exchanged for dollars. Conversely, when the
Department of MBA, SJBIT Page 102 pound is valued low, the supply of pounds for sale is smaller, reflecting less British desire to obtain U.S. goods.
Equilibrium
The demand and supply schedules for British pounds are combined in Exhibit 4.4. At an exchange rate of $1.50, the quantity of pounds demanded would exceed the supply of pounds for sale. Consequently, the banks that provide foreign exchange services would experience a shortage of pounds at that exchange rate. At an exchange rate of $1.60, the quantity of pounds demanded would be less than the supply of pounds for sale.
Therefore, banks providing foreign exchange services would experience a surplus of pounds at that exchange rate. According to Exhibit 4.4, the equilibrium exchange rate is $1.55 because this rate equates the quantity of pounds demanded with the supply of pounds for sale.
Factors affecting Foreign Exchange Rate
Aside from factors such as interest rates and inflation, the exchange rate is one of the most important determinants of a country's relative level of economic health. Exchange rates play a vital role in a country's level of trade, which is critical to most every free market economy in the world. For this reason, exchange rates are among the most watched, analyzed and governmentally manipulated economic measures. But exchange rates matter on a smaller scale as well: they impact the real return of an investor's portfolio. Here we look at some of the major
forces behind exchange rate movements.
Overview
Before we look at these forces, we should sketch out how exchange rate movements affect a nation's trading relationships with other nations. A higher currency makes a country's exports more expensive and imports cheaper in foreign markets; a lower currency makes a country's exports cheaper and its imports more expensive in foreign markets. A higher exchange rate can be expected to lower the country's balance of trade, while a lower exchange
rate would increase it.
Determinants of Exchange Rates
Numerous factors determine exchange rates, and all are related to the trading relationship between two countries. Remember, exchange rates are relative, and are expressed as a comparison of the currencies of two countries. The following are some of the principal determinants of the exchange rate between two countries. Note that these factors are in no particular order; like many aspects of economics, the relative importance of these factors is
subject to much debate.
Department of MBA, SJBIT Page 103 As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. During the last half of the twentieth century, the countries with low inflation included Japan, Germany and Switzerland, while the U.S. and Canada achieved low inflation only later. Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates. (To learn more, see Cost-
Push Inflation Versus Demand-Pull Inflation.)
2. Differentials in Interest Rates
Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates - that is, lower
interest rates tend to decrease exchange rates.
3. Current-Account Deficits
The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. Adeficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests.
4. Public Debt
Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. The reason? A large debt
Department of MBA, SJBIT Page 104 encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off
with cheaper real dollars in the future.
In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds, increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the country's debt rating (as determined by Moody's or Standard & Poor's, for example) is a crucial determinant of its
exchange rate.
5. Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments. If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater demand for the country's exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country's currency (and an increase in the currency's value). If the price of exports rises by a smaller rate than that of its imports, the currency's value will
decrease in relation to its trading partners.
6. Political Stability and Economic Performance
Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the
currencies of more stable countries.
Conclusion
The exchange rate of the currency in which a portfolio holds the bulk of its investments determines that portfolio's real return. A declining exchange rate obviously decreases the purchasing power of income and capital gains derived from any returns. Moreover, the exchange rate influences other income factors such as interest rates, inflation and even capital gains from
Department of MBA, SJBIT Page 105 domestic securities. While exchange rates are determined by numerous complex factors that often leave even the most experienced economists flummoxed, investors should still have some understanding of how currency values and exchange rates play an important role in the rate of return on their investments.
Forecasting foreign exchange rates
I. Forecasting Exchange Rates
International transactions are usually settled in the near future. Exchange rate forecasts are necessary to evaluate the foreign denominated cash flows involved in international transactions. Thus, exchange rate forecasting is very important to evaluate the benefits and risks attached to the international business environment.
A forecast represents an expectation about a future value or values of a variable. The expectation is constructed using an information set selected by the forecaster. Based on the information set used by the forecaster, there are two pure approaches to forecasting foreign exchange rates:
(1) The fundamental approach. (2) The technical approach.
1.A Fundamental Approach
The fundamental approach is based on a wide range of data regarded as fundamental economic variables that determine exchange rates. These fundamental economic variables are taken from economic models. Usually included variables are GNP, consumption, trade balance, inflation rates, interest rates, unemployment, productivity indexes, etc. In general, the fundamental forecast is based on structural (equilibrium) models. These structural models are then modified to take into account statistical characteristics of the data and the experience of the forecasters. It is a mixture of art and science
Practitioners use structural model to generate equilibrium exchange rates. The equilibrium exchange rates can be used for projections or to generate trading signals. A trading signal can be
Department of MBA, SJBIT Page 106 generated every time there is a significant difference between the model-based expected or forecasted exchange rate and the exchange rate observed in the market. If there is a significant difference between the expected foreign exchange rate and the actual rate, the practitioner should decide if the difference is due to a mispricing or a heightened risk premium. If the practitioner decides the difference is due to mispricing, then a buy or sell signal is generated.
1.B Technical Approach
The technical approach (TA) focuses on a smaller subset of the available data. In general, it is based on price information. The analysis is "technical" in the sense that it does not rely on a fundamental analysis of the underlying economic determinants of exchange rates or asset prices, but only on extrapolations of past price trends. Technical analysis looks for the repetition of specific price patterns. Technical analysis is an art, not a science.
Computer models attempt to detect both major trends and critical, or turning, points. These turning points are used to generate trading signals: buy or sell signals. The most popular TA models are simple and rely on moving averages (MA), filters, or momentum indicators.
There are numerous methods of forecasting exchange rates, likely because none of them have been shown to be superior to any other. This speaks to the difficulty of generating a quality forecast. However, this article will introduce you to four of the most popular methods for
forecasting exchange rates.
Purchasing Power Parity (PPP)
The purchasing power parity (PPP) is perhaps the most popular method due to its indoctrination in most economic textbooks. The PPP forecasting approach is based off of the theoretical Law of One Price, which states that identical goods in different countries should have identical prices. For example, this law argues that a pencil in Canada should be the same price as a pencil in the U.S. after taking into account the exchange rate and excluding transaction and shipping costs. In other words, there should be no arbitrage opportunity for someone to buy pencils cheap in one
country and sell them in another for a profit.
Based on this underlying principle, the PPP approach forecasts that the exchange rate will change to offset price changes due to inflation. For example, suppose that prices in theU.S. are expected to increase by 4% over the next year while prices in Canada are expected to rise by only 2%. The inflation differential between the two countries is:
Department of MBA, SJBIT Page 107
4% - 2% = 2%
This means that prices in the U.S. are expected to rise faster relative to prices in Canada. In this situation, the purchasing power parity approach would forecast that the U.S. dollar would have to depreciate by approximately 2% to keep prices between both countries relatively equal. So, if the current exchange rate was 90 cents U.S. per one Canadian dollar, then the PPP would forecast an exchange rate of:
(1 + 0.02) x (US$0.90 per CA$1) = US$0.918 per CA$1
Meaning it would now take 91.8 cents U.S. to buy one Canadian dollar. One of the most well-known applications of the PPP method is illustrated by the Big Mac Index, compiled and published by The Economist. This light-hearted index attempts to measure whether a currency is undervalued or overvalued based on the price of Big Macs in various countries. Since Big Macs are nearly universal in all the countries they are sold, a comparison of their prices serves as the basis for the index.
Relative Economic Strength Approach
As the name may suggest, the relative economic strength approach looks at the strength of economic growth in different countries in order to forecast the direction of exchange rates. The rationale behind this approach is based on the idea that a strong economic environment and potentially high growth is more likely to attract investments from foreign investors. And, in order to purchase investments in the desired country, an investor would have to purchase the country's currency - creating increased demand that should cause the currency to appreciate. This approach doesn't just look at the relative economic strength between countries. It takes a more general view and looks at all investment flows. For instance, another factor that can draw investors to a certain country is interest rates. High interest rates will attract investors looking for the highest yield on their investments, causing demand for the currency to increase, which again
would result in an appreciation of the currency.
Conversely, low interest rates can also sometimes induce investors to avoid investing in a particular country or even borrow that country's currency at low interest rates to fund other investments. Many investors did this with the Japanese yen when the interest rates in Japan were at extreme lows. This strategy is commonly known as the carry-trade.
Department of MBA, SJBIT Page 108 Unlike the PPP approach, the relative economic strength approach doesn't forecast what the exchange rate should be. Rather, this approach gives the investor a general sense of whether a currency is going to appreciate or depreciate and an overall feel for the strength of the movement. This approach is typically used in combination with other forecasting methods to
develop a more complete forecast.
Econometric Models
Another common method used to forecast exchange rates involves gathering factors that you believe affect the movement of a certain currency and creating a model that relates these factors to the exchange rate. The factors used in econometric models are normally based on economic theory, but any variable can be added if it is believed to significantly influence the exchange rate. As an example, suppose that a forecaster for a Canadian company has been tasked with forecasting the USD/CAD exchange rate over the next year. He believes an econometric model would be a good method to use and has researched factors he thinks affect the exchange rate. From his research and analysis, he concludes the factors that are most influential are: the interest rate differential between the U.S. and Canada (INT), the difference in GDP growth rates (GDP), and income growth rate (IGR) differences between the two countries. The econometric model he
comes up with is shown as:
USD/CAD (1-year) = z + a(INT) + b(GDP) + c(IGR)
We won't go into the details of how the model is constructed, but after the model is made, the variables INT, GDP and IGR can be plugged into the model to generate a forecast. The coefficients a, b and c will determine how much a certain factor affects the exchange rate and direction of the effect (whether it is positive or negative). You can see that this method is probably the most complex and time-consuming approach of all the ones discussed so far. However, once the model is built, new data can be easily acquired and plugged into the model to