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Title: AJAFIN 6605-05 International Monetary System, Exchange Rate Equilibrium and Exchange Rate Forecasting. The Evolution of International Monetary and Exchange Rate Systems:

AJAFIN 6605-05 International Monetary System,
Exchange Rate Equilibrium and Exchange Rate
Forecasting. The Evolution of International
Monetary and Exchange Rate Systems
  • A comprehensive chronology of exchange rate
    regimes is beyond the scope of this discussion.
    Such an account should include - the gold
    standard period, transition or wartime periods,
    controlled floating era, gold exchange standard,
    the "adjustable peg" of the Bretton Woods system,
    and the current floating exchange regime.

  • Definition The international Monetary System
    refers to a set of institutions, policies,
    practices, and mechanisms
  • that determine the rate at which one currency
    is exchanged for another.
  • Commodity Money Almost from the dawn of history,
    gold has been used as a medium of exchange
    because of its desirable properties. It is
    durable, storable, divisible,
  • and easily standardized. Also short-run
    changes in stock are limited by very high
    production costs.
  • Fiat Money Is paper money backed only by faith
    in the monetary authority that issues it. There
    is a near 100
  • profit margin on issuing new fiat money. By
    contrast, the net profit margin on issuing more
    money under the gold standard is zero. The
    governments cost of acquiring the extra gold
    equals the value of the new money it issues.

  • Three Distinct Regimes
  • 1. The Gold Standard Period (Circa 1879-1914)
  • The gold standard dates from 1819 when the
    British Parliament passed the so called
    "Resumption Act." The U.S. joined the
    international gold standard regime 1879, and gold
    was officially declared the "standard unit of
    value" in 1900 when the U.S. congress passed the
    "Gold Standard Act." During this period /
  • The UK established the British Pound () official
    price (its par value) in gold at 4.247 per
    ounce of gold while the US set the official price
    of the dollar at 20.67 per ounce of gold.

  • This implied a fixed rate of /
    20.67/4.247 4.8665.

  • Under the gold standard, currencies are valued in
    terms of their gold equivalent.

    Once each currency is defined in terms of
    its gold value all currencies are linked together
    in a system of fixed exchange rates.
  • A gold standard is a commodity money standard-
    money has a value that is fixed in terms of the
    commodity gold.
  • Why gold and not banana, orange, apple, or

  • Gold was chosen as a standard because it is a
    homogeneous commodity that is easily storable,
    recognized, portable, and divisible into standard
  • Also, governments cannot easily increase its
  • The adoption of the gold standard resulted in
    long-run price stability.
  • International trade was stimulated by the
    systematic linking of national currencies and the
    price stability of the system.

  • BOP Adjustment Under the Gold Standard
    (referred to as price-specie-flow mechanism)
  • Under the gold standard, a BOP disequilibrium is
    accompanied by a counter-flow of gold.
  • If the US imports more from Canada than it
    exports to Canada, gold, the only means of
    international payment, will flow from US to
  • The US will experience a decrease in money supply
    while Canada experiences an increase in money
  • Price level will fall in the US and rise in
  • Consequently, US products become more competitive
    and Canadian products less competitive.
  • This change will improve US BOP and hurt BOP of
    Canada eventually eliminating the initial

  • Exercise
  • Advantages disadvantages of the gold
  • Since the supply of gold is restricted, countries
    cannot have high inflation.
  • BOP disequilibrium can be corrected automatically
    through cross-border flows of gold.
  • World economy can be subjected to deflationary
    pressures due to restricted supply of gold.
  • The gold standard provided no mechanism to
    enforce the rule of the game, e.g.
    de-monetization of gold which is inconsistent
    with the gold standard.

  • 2. The Bretton Woods System 1946-1973.
  • In the summer of 1944, delegates from about 40
    nations met in Bretton Woods, NH, to work out
    arrangements for expanding international trade,
    promoting international capital flows, and
    fostering monetary stability.
  • The IMF grew out of this conference.
  • The conference also led to the establishment
    of the International Bank for Reconstruction
    and Development (aka The World Bank).

  • The Bretton Woods System is an "adjustable peg"
    system under which each country pledge to
    maintain the value of its currency within -1 or 1
    percent of its par value and make a change in
    exchange rates, but only in response to a
    "fundamental disequilibrium" and after
    consultation with the IMF.
  • Each member of the IMF sets a par value of its
    currency as an amount of its currency per dollar
    or an ounce of gold.
  • The price of gold was fixed in terms of dollars
    at 35 an ounce.

  • The system was soon beset with problems
  • By late 1960s, concern about the adequacy of
    Bretton Woods system was increasing.
  • Uncontrollable speculation against the dollar
    (in anticipation of dollar devaluation)
    finally took its toll.
  • In August 1971 the U.S. government suspended
    convertibility of official dollar reserves to
  • In June 1972, the U.K. abandoned the Bretton
    Woods exchange rate system and the sterling began
    to float relative to other currencies.
  • In March 1973 other major currencies adopted the
    floating exchange system.

  • Triffin Paradox
  • Triffin (1960) argued that a gold exchange
    standard is fundamentally flawed because of its
    reliance on a pledge of convertibility of a
    national currency into gold.
  • Under the Bretton Woods System, the dollar became
    the international reserve currency and the US
    began running large trade deficits to provide
    liquidity for the international monetary system.
  • To correct the BOP deficit the US would have to
    run a surplus and withhold dollars and this would
    create an international liquidity crisis.
  • On the other hand, if deficits were allowed to
    continue, crisis of confidence in the dollar as a
    reserve currency would undermine the system.

  • 3. Floating Exchange Rates 1973-present.
  • This system is best described as a "managed
    float." Central Banks sometimes intervene to
    obtain a "desirable" exchange rate apart from
    that which would be determined by free market
    supply and demand.
  • Some currencies are freely floating (e.g., the
    U.S. dollar) while others maintain a fixed value
    relative to a single currency and still others
    are pegged to a composite (basket) of currencies.
  • Some countries peg to the SDR. The European
    Monetary System (EMS) is a system in which member
    countries maintain fixed exchange rates among
    themselves, yet float against the rest of the
  • Some currencies are held fixed in a "crawling
    peg" where the exchange rate is held fixed is the
    short-run but is adjusted at regular intervals to
    reflect supply and demand.

  • International Agencies
  • International Bank for Reconstruction and
  • (IBRD) - one of 5 institutions in the World Bank
  • Established at the Bretton Woods in 1944.
  • Primary Objective is to make loans to countries
    in order to enhance economic development.
    Raises funds by sale of bonds
    and other debt instruments to private investors
    and governments profit-oriented.
  • Established Structural Adjustment Loans (SAL) in
    1980 and has since provided SAL to many
    developing economies that are attempting to
    improve their balance of trade.
  • Established MIGA (Multilateral Investment
    Guarantee Agency) which offers various forms of
    political risk insurance.

  • The IMF International Monetary Fund
  • Formed in 1944.
  • Major Objectives
  • Promote cooperation among countries on
    international monetary issues.
  • Promote stability in exchange rates.
  • Provide temporary funds to member countries.
  • Promote free mobility of capital funds across
  • Promote free trade.

  • The Special Drawing Right (SDR) is an
    international reserve asset, created by the IMF
    in 1969 to supplement existing official reserves
    of member countries.
  • SDRs are allocated to member countries in
    proportion to their IMF quotas.
  • The SDR also serves as the unit of account of the
    IMF and some other international organizations.
    Its value is based on a basket of key
    international currencies.

  • The SDR was created by the IMF to support the
    Bretton Woods fixed exchange rate system.
  • Member countries needed official reserves to
    purchase the domestic currency in the foreign
    exchange market to maintain appropriate exchange
  • International supply of two key reserve assets,
    gold and the U.S. dollar, proved inadequate for
    supporting the expansion of world trade and
    financial development.
  • The international community decided to create a
    new international reserve asset under the
    auspices of the IMF. Hence the SDR was born.

  • International Finance Corporation (IFC)
  • Established in 1956 to promote private enterprise
    within countries.
  • Uses private rather than government sector to
  • promote economic development.
  • International Development Association (IDA)
  • Created in 1960.
  • IDA extends loans at low interest rates to poor
  • nations, that cannot qualify or afford World
    Banks market-based conditions.

  • Bank for International Settlements (BIS)
  • The lender of last resort. Acts as a central bank
    for industrial countries central bank.
  • Facilitates cooperation, provides assistance.
  • Played a major role during the debt crisis (1970s
    and 1980s).
  • Helps central banks manage and invest their
    foreign exchange reserves.
  • Holds deposits of central banks so that reserves
    are readily available.

  • Supranational Banks
  • Supranational Banks (large multinational
  • with membership composed of countries, often
  • regional or religious lines Africa, Asian,
  • European, Inter-American, and Islamic.
  • These include
  • African Development Bank
  • Asian Development Bank
  • Council of Europe Development Bank
  • European Bank for Reconstruction and Development
  • European Investment Bank
  • Inter-American Development Bank
  • EUROFIMA (European Company for the Financing of
    Railroad Rolling Stock)
  • Nordic Investment Bank
  • Islamic Development Bank
  • Caribbean Development Bank

  • Exercise
  • Criteria for a good international monetary system
  • Provide sufficient liquidity to world economy
  • Provide smooth adjustment to BOP disequilibrium
  • Safeguard against a crisis of confidence in the

  • Exchange Rate Equilibrium
  • Exchange rates are market-clearing prices that
    equilibrate supplies and demands in the foreign
    exchange market.
  • In a two-country world, the U.S. and the U.K. for
    example, the demand for the pound derives from
    U.S. residents' demand for British goods,
    services, and pound-denominated financial assets.
  • An increase in the dollar value of the pound, (
    /), is equivalent to an increase in the dollar
    price of British products.
  • A higher dollar price will normally decrease U.S.
    demand for British products.
  • Conversely, a decrease in the dollar price of
    British products will increase U.S. demand for
    such products. Given these assumptions we have a
    downward sloping demand curve for the pound. (See

  • In the same way, the supply of pounds is based
    on British demand for U.S. goods, services, and
    dollar-denominated financial assets.
  • As the dollar value of the pound (/) increases
    (decreases), which lowers (raises) the pound cost
    of U.S. products, the increased (decreased)
    British demand for U.S. products will cause an
    increased (decreased) supply of the pound.
  • Thus we have an upward sloping supply curve for
    the pound.

The Demand for in the U.S.
/ Price

The Supply of in the U.S.
  • / Price

The / Equilibrium Rate
  • /

A US Depreciation
  • /


Equilibrium Exchange Rates
  • Currency Appreciation/Depreciation
  • (e1 - e0)/e0
  • where e0 old currency value
  • e1 new currency value

Equilibrium Exchange Rates
  • Example
  • Appreciation
  • If the dollar value of the goes from 1.25
    (e0) to 1.35 (e1), then the has appreciated
  • (1.35 1.25)/ 1.25 8
  • Consequently, the s depreciation against the
  • (1.25-1.35)/1.35 -7.4

  • Factors Influencing Exchange Rate Movements
  • 1) Relative Inflation Rates
  • Let ? inflation Rate, other things being
  • As ? increases in U.S., others things being
    equal, D by U.S. consumers increases.
  • This is because as prices increase in the U.S.,
    U.S. consumers will turn to U.K. suppliers.
    The increase in U.S. demand for
    U.K. goods and services causes an increase in the
    demand for the pound at each possible exchange
  • There exists an outward shift in demand schedule
    for the pound.

  • With higher inflation in the U.S., the decrease
    in British demand for U.S. products causes a
    decrease in the supply of the pounds exchanged
    for dollars.
  • Hence there exists an inward shift in the supply
    schedule for the pound.
  • The exchange rate will rise to the point where D
  • The dollar depreciates ( ).

  • 2) Relative (Real) Interest Rates
  • Consider the U.S. and the U.K. again.
  • Suppose, ius rises and iuk remains constant,
    others things being equal.
  • If U.S. rates are more attractive, capital flows
    from the U.K. to the U.S.
  • Hence S rises as British investors set up more
    bank deposits etc. in the U.S.
  • The D decreases as U.S. investors reduce their
    demand for the pound, since U.S. rates are now
    more attractive.
  • D shifts inward while S shifts outward.
  • Equilibrium exchange rate (/) rate decreases,
    i.e., the dollar appreciates. ( )

  • 3) Relative Income Levels (Economic Growth)
  • A higher relative US income (Yus) leads to
    increased consumption and therefore greater
    demand for British goods (U.S. imports increase)
    which leads to an outward shift in D.
  • Assume the supply of the pound (S) remains
    constant. Equilibrium exchange rate rises, i.e.,
    the dollar depreciates ( )
  • Note, however, that a nation with sustained
    economic growth will attract investment capital
    seeking to acquire domestic assets.

    The increased
    demand for domestic assets results in increased
    demand for domestic currency and therefore an
    appreciation of domestic currency.

  • 4) Government Controls
  • Include - foreign exchange barriers,
    intervention in
  • foreign exchange markets, etc.
  • 5) Political and Economic Risk
  • Investors prefer lesser amounts of riskier
  • Therefore low-risk currencies (from politically
  • economically stable nations) are more highly
  • than high-risk currencies.
  • 6) Expectation
  • Market's expectation of future exchange rates.
  • (reaction to news).
  • Expectation as a self-fulfilled prophesy!

  • The role of expectation in exchange rate
  • is based on the recognition of currencies as
    financial assets
  • and exchange rate as the relative price of
    two financial assets.
  • Therefore, currency prices are determined in the
    same manner
  • as the prices of stocks, bonds, or real
  • Asset prices are determined by investors
    willingness to hold
  • existing quantities of assets and this in
    turn depends on
  • investors expectation of the future
    benefits offered by these
  • assets.
  • The asset market model of exchange rate
  • therefore, suggests that a bilateral
    exchange rate represents the
  • price that just balances the supplies and
    the demands for assets
  • denominated in the two currencies.
  • Consequently, shifts in asset preferences will
    lead to shifts in
  • currency values.

  • 6) Interaction of Factors
  • Trade related factors and finance related
    factors may interact (goods vs. assets market).
    Note that
  • International trade f(inflation differential,
    income differential, government
    restrictions, etc.)
  • Financial flows f(interest rate differential,
    restrictions on capital flows, income
    differential, risk, etc.)
  • Simultaneous Interaction of Factors
  • Consider higher inflation, income and interest
    rate in the US. If British
    economy remains unchanged, higher inflation and
    income in the US will put upward pressure on the
    pound, while higher interest rate in US will
    exert a downward pressure on the pound.
  • The net result depends on the relative volume
    of international trade versus financial flows
    between the two countries.

  • Investor Psychology and Bandwagon Effects
  • Play a major role in short-run exchange rate
  • Can be influenced by political factors and
    corporate investment decisions.

  • Using An Index
  • The dollar's relative strength or weakness can be
    measured with an index, e.g., IMF index FRB
    index. The index is
    an international currency composite.
  • The index may be a weighted average of trading
    partner currencies (a currency composite).

    The weight assigned to a currency depends on
    its importance in international trade or finance.

    The index helps to track movements in the dollar.
  • For example, the Effective Exchange Rate (EER)
    (or trade-weighted exchange rate) of currency a
    is a weighted average of its exchange rate
    against a number of currencies c1, c2, cn. The
    weights are usually set proportional to country
    A's trade with the respective countries.

(No Transcript)
  • In general a weighted average is calculated
  • The EER is multilateral rather than bilateral.
  • The level of EER depends on the choice of a
    base year.

  • C. Forecasting Exchange Rates
  • Why MNC Forecast Exchange Rates?
  • Several corporate functions, for which exchange
    rate forecasts are necessary, include
  • 1. Hedging Decisions
  • The decision to hedge or not to hedge future
    payables/receivables may be determined by a
    firm's forecast of foreign exchange rates.
  • 2. Short-term "Financing" Decisions
  • When MNCs wish to borrow, they have access to
    several different currencies.

    Typically a currency to borrow from must
  • - Exhibit low interest rate.
  • - Be expected to depreciate over the financing

  • 3. Short-term "Investment" Decisions
  • MNC sometimes have excess cash.
    Deposits can be
    established in different currencies.
    The ideal currency for deposits should
  • - Exhibit high interest rate.
  • - Strengthen/appreciate over the investment
  • 4. Capital Budgeting Decision (International)
  • Capital budgeting decisions typically include
  • - Future cash inflows and outflows denominated
  • foreign currencies.
  • - Effect of future exchange rate changes on the
  • for a corporation's products.

  • 5. Long-term "Financing" Decisions
  • Foreign currency-denominated bonds may be
    issued. MNC will prefer currency of denomination
    to depreciate over time.
  • Note that borrowing a depreciating currency may
    set the debtor free in the long run.
  • Example
  • In 1981 issue bonds 1m 12m Pesos
    (Peso/dollar 12)
  • In 1990 1 2700 P, therefore, 12m P 4400
  • The original 1m loan can then be paid off with

  • At 10,000 peso/ in 1998, original principal
  • At 14,000 P/ in 02/09, Original principal
    loan 857!

  • 6. Earnings Assessment
  • In a MNC's consolidated financial statements,
    subsidiary financial statements are translated
    into parent firm's home currency.
  • The value of the MNC at a point in time (or
    forecast of its consolidated earnings) will
    require exchange rate forecasts.

  • Forecasting Techniques
  • 1. Technical Forecasting
  • Involves the analysis of a historical series of
    exchange rates to determine whether some
    non-random patterns exist, and making projections
    based on such patterns.
  • 2. Market-Based Forecasting
  • Is the process of developing forecasts from
    market indicators. Usually based the spot rate or
    the forward rate.

  • 3. Fundamental Forecasting
  • Use of fundamental relationships between
    economic variables and exchange rates.
  • This method employs statistical models such
    as regression analysis to determine the
    responsiveness or sensitivity of exchange rates
    to relevant factors selected on the basis of a
  • It develops forecasts of currency values
    based on the current values of these factors,
    e.g., exchange rate f(income, money, interest,
  • 4. Mixed Forecasting
  • No single forecasting technique has been found
    to be consistently superior to others.
    forecasting uses a combination (weighted average)
    of several forecasting techniques.

  • Forecasting Under Different Regimes
  • Fixed-rate System
  • Under fixed exchange rates, the authorities are
    committed to preventing any variation in currency
  • They achieve this by instituting controls on
    transactions in foreign exchange or by direct
    intervention in the market to buy up excess
    supply of domestic currency with other
    convertible currencies, and conversely, to supply
    additional domestic currencies when there is
    excess demand.
  • Fixing the exchange rate, therefore, entails
    surrendering control over the domestic money
  • In a fixed-rate system the government's
    objectives are clear- there is a commitment to
    maintain a fixed rate.
  • Forecasting is therefore focused on the ability
    of authorities to hold to their commitment.

  • The balance of payment (BOP) for official
    financing is not identically zero.
  • Surpluses or deficits are covered by the use of
    foreign currency reserves to intervene in the
    currency markets.
  • In the L-R, however, relative rates of inflation
    and other economic forces determine the required
    adjustments in exchange rates.
  • In the S-R, governments can sustain persistent
    B.O.P. disequilibrium.
  • Important factors impacting the change in a fixed
    exchange rate include - key political decision
    makers, ruling party's ideology, upcoming
    elections, etc.
  • Other indicators include - BOP deficits, future
    economic prospects, inflation differential, money
    supply growth, excessive government spending, etc.

  • Steps in Forecasting Fixed Exchange Rates
  • Step 1 Evaluate Economic Pressures on the
    Currency Value
  • a. Study balance of payments behavior and
    compare it to balance of payments' developments
    in other countries.
  • b. Compare past and expected inflation rates
    to developments in other countries.
  • c. Compare past and expected GNP growth rates
    to developments in other countries.
  • d. Compare past and expected interest rates to
    developments in other countries.
  • e. Study other economic factors that are
    known to put pressure on exchange rates.

  • Step 2 Evaluate the Possible Impact of Economic
    Policy Alternatives
  • a. Evaluate the political and economic
    consequences of changing the value of the
  • b. Evaluate the political and economic
    consequences of foreign exchange control.
  • c. Evaluate the political and economic
    consequences of placing limits on the movement
    of capital into and out of the country.
  • d. Evaluate the political and economic
    consequences of policies designed to effect
    domestic growth, inflation, and interest rates.

  • Step 3 Evaluate Political Pressures on Decision
  • a. Examine the political philosophy and
    platform of the
  • government in power. Opposition parties
    that have a
  • likelihood of gaining power must also be
  • b. Study the personality and personal
    objectives of the
  • powerful political figures who would have
    to approve a
  • decision to devalue or revalue a
  • c. Study the pressures being exerted by
    political allies and
  • important economic partners.
  • d. Evaluate the election period phenomenon as
    it applies
  • to the country in question.
  • Step 4 Make an Educated (judgmental) Forecast

  • Freely Floating Exchange Rates
  • A completely flexible (or purely or freely or
    cleanly) floating exchange rate is one whose
    level is determined exclusively by the underlying
    balance of supply and demand for the currency
    involved, with no intervention from the monetary
  • Supply and demand schedules are in turn functions
    of relative inflation rates, real interest rate
    differentials, and relative rates of economic
    growth, etc.
  • Managed or Dirty Float Exchange Rates
  • Is a system where the government intervenes at
    its own discretion. This term best describes the
    current (1973-date) exchange rate regime.

  • Fixed Exchange and Floating Exchange Rates
  • Advantages of Fixed
  • No speculation
  • Certainty
  • Prevents irresponsible
    government policies.
  • Disadvantages of Fixed
  • Conflicts with other macro
  • Difficulties in adjusting to
  • Problems of international

  • Advantages of Floating
  • Automatic correction
  • Insulation from external events
  • Less constrain on domestic
    macro policies.
  • No problem of international
  • Disadvantages of Floating
  • Possibility of unstable
    exchange rates.
  • Speculation
  • Businesses incur costs to
    manage risk
  • Lack of discipline on the

  • Currency Forecasting and Market Efficiency
  • A financial market is said to be efficient
    if it is composed of numerous "well-informed"
    participants, with ready and costless (cheap)
    access to new information, whose trading
    activities cause prices to rapidly adjust to
    reflect all available information.
  • Price changes at any moment must, therefore,
    be due to the arrival of new information.
  • Since new information arrives randomly, price
    changes follow a random walk, i.e., they are
    serially uncorrelated.
  • The spot rate will move in an unpredictable
    manner which is a rational response to new (and
    unpredictable) information, i.e., probability of
    a positive change equals the probability of a
    negative change, so that

  • Definition
  • A time series Xt is said to follow a (pure)
    random walk if the change in Xt from one period
    to the next is purely random, i.e.,
  • Xt Xt-1 Ut
  • Xt - Xt -1 ?Xt Ut
  • Random walk refers to the path of a variable
  • whose changes are impossible to predict.
  • If markets are efficient, all stocks are
    fairly valued and no stock is more likely to
    appreciate than another.
  • Thus stock prices follow a random walk.

  • More Generally
  • A time series Xt is said to follow a random walk
    with a drift, d, if the change in Xt from one
    period to the next is equal to a drift factor, d,
    plus a purely random component,
  • Xt Xt-1 d Ut
  • or
  • Xt Xt-1 ?Xt d Ut
  • That is, there exists a long-run upward trend or
    downtrend in the behavior of Xt . This means
    that on average the process will tend to follow
    the sign of d.
  • Note that even if Xt is a random walk, this does
    not rule out the possibility that future changes
    can be "predicted" using a broader information
  • A random walk univariate process indicates that
    lagged values of a variable itself cannot be used
    to predict future changes in the variable.

  • Forms of Efficiency
  • Weak-form Efficient Reflects all historical and
    current information is reflected in current
  • Semi-strong Form Efficient All relevant public
    information is reflected in current prices.
  • Strong-form Efficient All relevant public and
    private information is reflected is reflected in
    current prices.
  • Empirical tests of foreign exchange market
    efficiency provide no clear-cut evidence.

    However, they paint a picture of rapid
    adjustment by exchange rates to new information.
  • In general, the exchange market has been found to
    be semi-strong efficient. MNCs still forecast
    exchange rates.
  • The goal is not necessarily to earn speculative
    profits but to use reasonable forecasts to
    implement policies.

  • Technical Forecasting Two types.
  • Charting Based on bar charts and computer
    extrapolations to identify recurrent price
    patterns, and find a trading rule to "beat the
  • Trend-following Use of mathematical models to
    identify trends. A typical system used by some
    traders can be defined as
  • An X filter rule allows a would be speculator
    to profit from a trend by
  • -- buying a currency when the exchange rate
  • rises by X from a trough.
  • -- selling a currency "short" whenever it falls
    by X from a peak.

  • Technical Models
  • Use of currency price and volume data to forecast
    future exchange rates.
  • Involves conditional probabilities and
    informational economics.
  • The notion of mean-reversion - support and
    resistance levels mean-reverting to the trend.
  • The concept of momentum channel breakout
    moving averages.

  • The technical analyst must discover price
    trends/patterns that can be forecast.
  • Also duration, and extent, must be ascertained to
    permit investors to recognize and profit from
  • Technical analysis is inconsistent with market
  • Nevertheless, technical analysis is extensively
    used by market participants and sometimes
    technical charting outperforms other methods.

  • Challenges to Market Efficiency
  • Stock market crashes 1929, 1987, 2008..
  • Temporal anomalies day-of-the-week, weekend,
    month-of-the-year, end-of-year effects.
  • Speculative bubbles occasional situations where
    herd / crowd mentality appears to move above
    rational levels.
  • Behavioral Challenges
  • Rationality People are not always rational.
  • Many investors fail to diversify, trade too
    much, sell winners, and hold losers .

  • According to psychologists, people deviate from
    rationality in some predictable ways
  • - Representativeness Drawing conclusions from
  • too little data bubbles may result.
  • - Conservatism people may be too slow in
    adjusting their belief to new information prices
    may respond slowly to earning surprises.
  • Limits to Arbitrage Markets can stay irrational
    longer than you can stay solvent (Keynes)
  • Size Small caps seem to outperform large caps
  • Growth vs Value High book-value-to-market-value
    stocks and low P/E stocks outperform growth

  • Market-Based Forecasts
  • Derived from current spot and forward rates.
    For example, the FRP
  • S0 St
  • ---------------------------
  • Ft
  • Given St ? Ft , then
  • There exists disagreement on whether forward
    rates are unbiased predictors of future spots or
    whether the forward premium (discount) is an
    unbiased predictor of future changes in exchange
  • The forward rate may be a poor predictor of
    future spot, probably because spot rates adjust
    quickly to the value warranted by the markets
    expectation of future policies so that most
    changes are due to new and unpredictable

  • Market-based forecasting rests on two hypotheses
  • The random walk (RW) hypothesis
  • The unbiased efficiency hypothesis
  • The RW states that period-to-period changes in
    spot exchange rates are random and unpredictable,
  • The spot rate at time t1 is equally likely to
    overstate or understate the rate at t. Therefore
    the best forecast of the rate for time t1 is the
    rate at time t.
  • The unbiased efficiency hypothesis posits that
    the current fwd rate is an unbiased and efficient
    forecaster of future spot rate at maturity of the
    forward contract.
  • The fwd rate reflects the markets expectation of
    the level of the spot rate in the future.

  • Advantages and Disadvantages of Forward Rates
  • Forward rates are simple, easy to use and
    relatively cheap to obtain.

    But forecasting horizon is limited to about 1
  • It is also less accurate as time to maturity
  • Interest rate differential (can be) used for
    predictions beyond 1 year b invoking the
    uncovered interest rate parity theory.

  • Empirical Behavior of the Exchange Rates
  • Empirical studies of S-T behavior of major
    currencies during the floating rate period
    revealed the following general characteristics
  • Month-to-month variability in bilateral spot
    rates is frequently large and almost entirely
  • There is a strong positive correlation between
    spot and contemporaneous forward exchange rates
    (correlation of about .99).
  • Another empirical regularity is that short term
    variability of nominal exchange rates has been
    significantly greater than the variability of
    relative national price levels.

  • There is strong evidence that the variability of
    nominal and real exchange rates differs across
    alternative exchange rate regimes. (e.g. Bretton
    Woods vs. Freely Floating)
  • A number of questions are therefore immediate
  • Why do expected changes in exchange rates seem so
    small relative to unexpected changes?
  • Why are real and nominal rates so highly
  • Why do most changes in real rates persist for
    very long periods of time?
  • What accounts for differences in nominal/real
    exchange rates across regimes?

  • Fundamental Analysis
  • Is based on macroeconomic variables that are
    likely to influence a currency's value
    inflation rates, interest rates, national income
    growth, money supply growth rates, balance of
    payment positions
  • Involves ascertaining supply and demand for a
    currency by studying various economic indicators
    and other economic data that will affect the
    supply and demand for each currency relative to
    the another.
  • The effect of each variable on exchange rates
    depends on the model used.
  • Econ indicators carry trade, non farm
    payroll employment, housing starts, industrial
    production/capacity utilization, retail sales,
    business sales and inventories, durable goods
    shipments, new orders and unfilled orders. auto

  • The Traditional Flow Model
  • The "international trade flows" model emphasizes
    the role of exchange rates in eliminating
    international trade imbalances.
  • The emphasis is on international trade in
  • This model assumes that currency values are
    determined by supply and demand flows in the
    foreign exchange market.
  • Different economic variables are analyzed for
    their balance of payment impacts.
  • In eliminating BOP imbalances (current account
    and capital account), supply and demand for a
    currency, and hence its value, can be determined.

  • The Current Account f(business cycles,
  • (Pd - Pf), relative inflation, has a negative
    effect on current account leading into the
    depreciation of (domestic) currency.
  • Supply and demand for domestic currency in the
    foreign exchange market are influenced by real
    income differentials, (Yd Yf).

  • The Capital Account
  • Savings - Real Domestic Investment, S - Id,
    depends on national propensities to save and
  • Savings and Investments f(interest rates).
  • Interest Rates f (M, Pd, government policy,
    business cycles ...)
  • Real Interest Rate Differential is what matters
    in attracting capital flows and r ? i p .
  • Therefore an increase domestic real interest
    rate attracts capital inflows resulting in the
    appreciation of domestic currency.

  • The traditional flow model can be stated as
  • where
  • Pd, Pf domestic and foreign price
  • Yd, Yf domestic and foreign income levels
  • rd, rf domestic and foreign interest rates
  • . et error term

  • Asset Market Models
  • Many financial economists reject the view that
    short-term behavior of exchange rates is
    determined in the purely "flow" markets.
    Rather they posit that
  • Exchange rates are asset prices traded in an
    efficient financial market.
  • The exchange rate is the relative price of two
    currencies and its value is therefore determined
    by the relative willingness of market
    participants to hold each currency.

  • Like other assets, therefore, it is determined by
    expectations about the future, not current trade
  • Only news about future economic prospects, not
    current international flows, will affect exchange
  • The common denominator of financial assets,
    (stocks, bonds, and exchange rates), is that they
    are forward-looking so that their values depend
    on the present value of future benefits they

  • Since a currency provides services such as
  • a medium of exchange (as a store of liquidity)
  • provides transaction services.
  • a store of value determined by its expected
  • inflation.
  • a store of wealth demand for assets
  • denominated in a currency affects its
  • A currency's value depends on the current
    expectation of all future variables that help
    determine the value of the services provided by
    the currency.

  • Relevant economic factors therefore include a
    country's anticipated inflation rate, risk/return
    on investments in that country, etc.
  • These factors, in turn, depend on the country's
    expected monetary and fiscal policies, as well as
    political and economic stability.

  • Therefore, contrary to the traditional flow
  • Yd (sustained higher domestic relative
    income results in domestic currency appreciation)
  • Trade or current account balance should bear no
    determinate relationship with the exchange rate.
  • In contrast to the traditional view that exchange
    rates adjust to equilibrate international trade
    in goods, the asset view posits that exchange
    rates adjust to equilibrate international trade
    in financial assets.

  • Since financial asset prices adjust faster than
    goods prices, this shift in emphasis from goods
    to financial markets has important implications.
  • Exchange rates will change as the supply and the
    demand for financial assets denominated in
    different currencies change.

  • There are 2 groups in the family of asset
  • (a) The Monetary Approach.
  • (b) The Portfolio-balance Approach.
  • In the monetary approach, the exchange rate for
    any two currencies is determined by relative
    money demand and money supply between the two
    Relative supplies of
    domestic and foreign bonds (assets) are not
  • In addition, while monetary approach models
    assume that domestic and foreign bonds are
    perfect substitutes, the portfolio-balance models
    assume imperfect substitutability of domestic and
    foreign bonds.

  • If domestic and foreign bonds are perfect
    substitutes, then bond holders are indifferent
    between the currency of denomination as long as
    the expected return is the same.
  • It follows, therefore, that bond holders do not
    require a premium to hold foreign bonds.

    Uncovered interest rate parity holds in
    monetary approach models.
  • If domestic and foreign bonds are imperfect
    substitutes, then holders have desired portfolio
    share for any particular country's assets.
  • If the supply of any particular country's assets
    increases, investors will hold a greater
    proportion of that country's assets only if they
    are compensated.
  • This means that a premium is required on these

  • Portfolio-balance Models
  • Have risk premia that are functions of
    relative asset supplies.
  • As country X's supply of financial assets rises
    relative to Y's, investors will demand a higher
    premium on X's assets.
  • Therefore, unlike the monetary approach,
    uncovered interest rate parity will not hold
    because of the existence of risk premia in
    financial markets.
  • In general, the portfolio-balance model modifies
    the monetary model by including the supply of
    domestic bonds (Bd) relative to foreign bonds

  • The Portfolio-balance approach can be expressed
  • where
  • Bd log of supply of domestic bonds.
  • Bf log of supply of foreign bonds.
  • ex exchange rate (d/f), e.g., /
  • md, mf , domestic and foreign money supplies.
  • Pd, Pf , domestic and foreign price indices.
  • Yd, Yf , domestic and foreign income levels.
  • id , if , domestic and foreign
    interest rates

  • The Monetary Model
  • This model posits that the exchange rate can be
    interpreted as the relative price of two
    currencies determined by equilibrium on their
    money markets.
  • Basic Assumptions
  • - Goods prices are completely flexible (absolute
    ppp holds)
  • - Domestic and foreign assets are perfect
  • - There is perfect capital mobility.
  • - Money supply and real income are exogenous -
  • or determined outside the model.

  • The Model
  • Money market equilibrium conditions
  • Md is a positive function of P, a positive
    function of Y, and a
  • negative function of i.
  • Along with the PPP which states
  • from (1) - (3) we have
  • According to the monetary model

  • An increase in Ms leads to an increase in
    nominal interest rate through anticipated price
    changes (inflation)
  • Yd real demand for money, in price
    level, and to obtain money market equilibrium,
    domestic currency appreciates,
  • i.e., (also through PPP).
  • i d M d to hold, and given a fixed
    nominal money supply
  • Pd (a domestic currency
  • The nominal interest rate in the monetary model
    is interpreted in terms of inflationary
    expectation, since perfect substitutability of
    assets and capital mobility imply that real rates
    are equalized.
  • Notice the difference in the predicted effects
    of domestic interest rate and domestic real
    income in the traditional flow model and the
    monetary model.

  • Note
  • For a form of money to act as a store of value,
    it must be able to be reliably saved, stored and
    retrieved, and be predictably useful when so
  • The standard of deferred payment function
    requires acceptability to parties to whom one
    owes a debt.
  • The unit of account function requires fungibility
    so that accounts can be readily settled.
  • The medium of exchange function requires
    durability when used in trade.
  • When a currency is stable it can serve all these
    functions, otherwise other forms of stores of
    value come into play e.g. real estate, gold,
    collectibles, and livestock.

  • Evaluating Forecasting Accuracy
  • Absolute Forecast Error Abs (Forecast -
  • As a of realized error
  • The forecast error from different models can be
  • over time to determine relative performance of
    these models
  • Note Several views on exchange rates and
    interest rates are expressed in the literature
  • A higher rate of domestic interest (real rate)
    attracts foreign capital inflows which induces a
    surplus in the capital account of the BOP and
    thereby induces an appreciation of domestic

  • A higher interest rate lowers (investment)
    spending and thus induces a surplus in the
    current account of the BOP which results in the
    appreciation of the domestic currency. (Firms
    with investment spending projects will only go
    ahead if they expect a higher return than their
    cost of funds. If interest rates rise, fewer
    projects will pass this test resulting in lower
    investment spending.
  • A higher rate of domestic interest implies a
    (higher) forward premium on a foreign currency
    (via IRPT). The required (higher) forward premium
    will be brought about by a depreciated domestic
    currency in the spot market.
  • A higher domestic inflation (implies a higher
    nominal rate of interest) increases imports,
    reduces exports and induces a current account
    deficit and leads to a depreciation of domestic

Currency Crisis (86115)
  • A currency crisis features speculative attacks
    in the form of heavy selling..
  • Country experiences depleting foreign exchange
  • Forward rate for currency continues to fall
  • Possible capital flight
  • Economy negatively impacted
  • Government efforts to manage the crisis
  • Allowing currency to float
  • Devaluation
  • Capital controls
  • Obtaining foreign loans (e.g. from the IMF)
  • Implementing domestic policy changes.

Causes of Currency Crisis
  • Budget deficits financed by inflationary
  • Faltering economy and weak financial system
  • Political crisis
  • External shocks
  • Fixed exchange rate that government cannot
  • Guaranteed bailout for mismanaged financial
  • Financial Crisis in General e.g. SL and
  • Dont chase a boom without planning for a burst
  • Be sure subordinates feel save delivering bad
  • Ensure that incentive systems do not encourage
    excessive risk
  • Master the instrument/product dont gloss over
    complicated details
  • Watch out for irrational exuberance (pessimism?)

  • 1. The Peso Problem
  • Dec. 20, 1994, Mexico devalued its peso by
  • Two days later, Mexico was forced to let the peso
    float freely. It quickly fell an additional 15.
    By March 1995 the peso had
    fallen a total of 50.
  • The US government and various international
    financial institutions provided a rescue package
    of 52 billion
  • in loans and loan guarantees.
  • The pesos problem illustrates the importance of
    credibility in establishing currency values.
  • Credibility depends on the degree of consistency
    in exchange rate policy and other macroeconomic

  • The major part of the problem started in December
    1994, when Mexican government found itself unable
    to service its tesobonos, a series of
    short-term government bonds.
  • The crisis came to be called tesobono or
    tequila crisis (the hangover that drinkers get
    the day after a tequila binge).
  • Mexicos problem quickly expanded into a crisis
    for the entire region.
  • A broadly-based sell-off of Latin American
    equities and currencies ensued.
    The effect was
    strongest in Argentina and, to some extent,
    Brazil, but the entire region was affected in
    some way.

  • 2. The Russian Ruble Troubles.
  • The Soviet Union disintegrated in 1991. The
  • government had difficulty managing its
  • It was spending more than was collecting in
    revenues resulting in persistent deficits
    financed by printing rubles and issuing
    short-term treasury bills.
  • By late 1997, rapidly increasing debt issuance
    and falling
  • commodity prices increased investors fears
    about Russias ability to service its debts
    including 160 billion in foreign debt.
    Speculation against the ruble ensued.
  • The government responded by repeatedly raising
  • rates. Interest rates reached 150 by May
  • The crisis and the governments response resulted
    in steep
  • rise in inflation and a deep recession in

  • 3. Currency Crisis in East Asia, 1997-98.
  • In mid 1997, beginning in Thailand, currency and
  • markets plunged across East Asia.

    Depreciations of 40 to 80 in currency values
    were experienced in Thailand, Indonesia,
    Malaysia, Philippines, and South Korea.
  • Despite apparently positive economic signs,
  • were concerned that many Asian economies were
  • on unsustainable courses . large trade
    deficits, huge
  • short-term foreign debts, overvalued
    currencies, and
  • crony capitalism.
  • Many of the countries tied their currencies to
    the dollar
  • and this served very well up till 1995 by
    promoting low
  • inflation and currency stability.

  • It boosted their exports at the expense of Japan
    as the
  • dollar fell against the yen.
    stability also led Asian banks and companies to
    finance themselves in hard currencies up to 275
    billion, much of this in short-term loans.
  • Then the dollar began to rise against the yen and
  • currencies. By mid 1997, the dollar had risen
    about 50
  • against the yen and about 20 against the
  • At the same time the Chinese yuan depreciated
    against the dollar by about 25.
  • The yuans depreciation raised Chinas export
  • competitiveness at East Asias expense.
  • Speculators attacked East Asian currencies

  • 4. Currency Crisis in Argentina.
  • Argentina is considered one of Latin Americas
  • currency basket cases. Decades of excessive
  • spending financed by printing money triggered
  • vicious cycle of inflation and devaluation.
  • In 1991, after 50 years of economic
    mismanagement, the country launched the
    Convertibility Act which made the countrys
    currency fully convertible at a fixed rate to the
    dollar and, by law, money supply had to be 100
    backed by gold or convertible currencies.
  • The government could no longer print money to
    support a
  • budget deficit.
  • In January 1992, Argentina renamed its currency,
  • austral, the peso, and made it worth exactly
    one dollar.

  • The convertibility act effectively locked the
    country into
  • U.S. monetary system and restored confidence
    in the peso.
  • Inflation fell from 2,300 in 1990 to 170 in
    1991, 4
  • in 1994 and only 0.4 in 1997.
  • Argentinas economy then suffered from a series
  • external shocks and internal problems.
    These include the falling prices
    for its agricultural commodities, the Mexican
    peso crisis of 1994, the Asian currency crisis of
    1997, and the Russian and Brazilian financial
    crisis of 1998-1999.
  • The devaluation of the Brazilian real in 1999,
    and the
  • appreciation of the dollar in late 1990s made
  • products less competitive both at home and

  • Argentina also faced internal problems of rigid
    labor laws that made it costly to lay off workers
    and excessive government spending.

    The increased spending was first funded by
    privatization proceeds and later by tax increases
    and heavy borrowing. The result was massive
    deficits, rising debt burdens, high unemployment,
    and economic stagnation.
  • In June 2001, the government announced a dramatic
  • change in policy to stimulate the economy.
    A new basket was announced for
    the peso.
    Financial markets panicked.
    Over the next
    six months the countrys bold currency experiment
    The government
    announced in January 2002 that it will end the
    decade old currency board.
    The consequences were

  • By the end of 2002, the currency had depreciated
    by 70. A clear lesson from Argentinas failed
    currency board experiment is that exchange rate
    arrangements are no substitute for sound
    macroeconomic policy.
  • The peso and its currency board collapsed
    following the determination by domestic and
    foreign investors that the countrys fiscal
    policies were unsound and incompatible with the
    maintenance of a fixed exchange rate.

  • 5. Currency Crisis in Brazil, 1999.
  • Brazil had long had severe problems with
  • In 1993, the Real Plan was introduced in
    Brazil as a stabilization package.

    The plan controlled existing runaway inflation,
    balanced the budget and reduced government
  • It introduced a new currency, the Real, which was
    pegged to the dollar.
  • The real was allowed to fluctuate within
  • bands that were periodically adjusted.
    This regime
    lasted from 1995-1999.
  • A small controlled devaluation was built into the
    system to accommodate Brazilian deviations from
    U.S. inflation rates.

  • Although the currency was successful in calming
  • it was not able to fully reconcile the
    discrepancy between
  • Brazilian and U.S. inflation rates.
  • As a result the real became overvalued leading to
    a current account deficit.
  • The huge deficit was more than offset by capital
  • as foreign investors acquire Brazilian
    assets. The country
  • accumulated foreign reserves in excess of 70
  • Since the currency was so dependent on foreign
    investments to prop up its value, it became
    vulnerable to a currency crisis if investors
    withdraw their funds at a rapid rate.
  • Several conditions triggered a mass exodus of
    funds and the eventual devaluation of the real,

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