Download Foreign Exchange Rate Forecasting

Foreign Exchange Rate Forecasting
If you KNOW FOR SURE what exchange rates will be… you
could make millions of dollars IN ONE DAY… so this is all about
FORECASTING what the exchange rate will be (to make money)
Background:
Infrastructure weaknesses were among the major causes of the
exchange rate collapses in emerging markets in the late 1990s.
and also explain why the U.S. dollar continued to be strong, at
least until the September 11,2001, despite record balance of
payments deficits on current account.
Speculation contributed greatly to the emerging market crises.
Characteristics of speculation are hot money flowing into and out
of currencies, securities, real estate, and commodities.
*Uncovered interest arbitrage caused by exceptionally low
borrowing interest rates in Japan coupled with high real interest
rates in the United States was a problem for much of the 1990s.
*Borrowing yen to invest in safe U.S. government
securities, hoping that the exchange rate did not change,
was popular.
Cross-border foreign direct investment dried up during their
crises.
Foreign political risks have been much reduced in
recent years as capital markets became less segmented from
each other and more liquid. More countries adopted democratic
forms of government.
Contagion is defined as the spread of a crisis in one country
to its neighboring countries. Contagion can cause an
“innocent” country to experience capital flight and a resulting
depreciation of its currency. Speculation can cause a
foreign exchange crisis or make an existing crisis worse
THEORIES to forecast exchange rates…
In order to make MONEY!!!!
1. Purchasing Power Parity Approaches
The most widely accepted theory of all exchange rate
determination theories, the theory of purchasing power parity
(PPP), states that the long-run equilibrium exchange rate is
determined by the ratio of domestic prices relative to foreign
prices.
PPP is both the oldest and most widely followed of the
exchange rate theories.
PPP calculations and forecasts, however, may be plagued
with structural differences
2. Balance of Payments (Flows) Approaches
The second most frequently used theoretical approach to
exchange rate determination is probably the balance of payments
approach.
• The basic balance of payments approach argues that the
equilibrium exchange rate is found when the net inflow
(outflow) of foreign exchange arising from current account
activities matches the net outflow (inflow) of foreign
exchange arising from financial account activities.
• Criticisms of the balance of payments approach arise
from the theory’s emphasis on flows of currency and capital
rather than stocks of money or financial assets.
3. Monetary Approaches (less popular, less important)
The monetary approach states that the exchange rate is determined by the
supply and demand for and growth of national monetary stocks.
Changes in the supply and demand for money are the primary determinants of
inflation.
In monetary models of exchange rate determination, real economic activity is
relegated to a role in which it influences only exchange rates through any
alterations to the demand for money.
The monetary approach omits a number of factors
1) the failure of PPP to hold in the short to medium term; 2) money
demand appearing to be relatively unstable over time; and 3) the level of
economic activity and the money supply appearing to be interdependent.
4. Asset Market Approach (Relative Price of Bonds)
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.
Unfortunately, none of the fundamental
theories have proven that useful in the short
to medium term to predict exchange rates!
5. Technical Analysis USING CHARTS TO FIND TRENDS
The belief that the study of past price behavior provides insights
into future price movements.
The primary feature of technical analysis is the assumption
that exchange rates, follows trends. And those trends may
be analyzed and projected.
6. The Asset Market Approach to Forecasting
EXCHANGE RATES based on DEMAND of a currency by
foreigners based on:
• Relative real interest rates
• Prospects for economic growth and profitability
• A country’s economic and social infrastructure
• Political safety
• The credibility of corporate governance.
1990’s: The heavy inflow of foreign capital into the U.S. stock market and
real estate, motivated by good long-run prospects for growth and
profitability in the United States. This time the bubble burst following the
September 11, 2001, terrorist attack on the United States. Loss of
confidence in the U.S. … dollar depreciated.
Asian Crisis:
1980’s Asian countries became EXPORTERS… growth opportunities went
up. Investor money flowed in. THEN citizens got wealthy and countries
became NET IMPORTERS. So investor money became more important to
fund their growth. Citizen’s savings rate went down. Needed outside money
to fund growth. Started borrowing too much money from outsiders.
1997: investors got worried of debt default… pulled money OUT of
Thailand, then out of Indonesia, Philippines, Malaysia, Hong Kong, Korea.
Currencies came under attack, money was made on puts and selling
forward contracts as currencies dropped as investors pulled money OUT of
those countries. Hong Kong, Japan, and China were not effected much due
to their strength.
Tequilia Effect: 1994 drop in Mexican Peso soon spread to Latin American
Countries. 1997: Drop in Thai Bhat spread to other Asian countries.
Argentina: had horrible inflation in 1980’s. Hurts economy.
Solution: adopted a currency board – for each peso on streets… held 1 US
dollar in reserves. It worked well to keep inflation down for a few years.
Problem: couldn’t get enough MORE dollars in reserves in order to expand
Peso money supply on streets. Economy slowed to a halt. 2001: Peso
overvalued, monetary policy was eliminated, gov. budget deficits.
2001: unemployment, riots, bank runs, several Presidents came and went
Result: devalued Peso (floated it)… Peso then fell dramatically. Argentina
has since recovered somewhat.
Venezuela:
1998: Chavez elected with liberal promises. Adopts isolationist policy.
Bolivar depreciates. People tried to dump Bolivars. Chavez made is more
difficult to dump Bolivars and buy dollars. Businesses NEEDED dollars to
buy medicines, etc. from overseas. Had trouble getting the dollars under
Chavez. Chavaz set an exchange rate but blackmarket rate was different.
CADVI was a government agency to help obtain dollars but had to be a
supported to go through that route. Anti-Chavez petitioners were denied.
LOOPHOLE: you could buy stock in CANTV with Bolivars… then later sell
stock for dollars. All of this HURTS the economy of Venezuela. High oil
prices help though bring in hard dollars to Venezuela.