PRESENTATION

ON

exchange rate determination

&
forecasting

PRESENTEDBY :
SHAILY SRIVASTAVA
SNEHA KUMARI
MANJUNATH
ANAMIKA SRIVASTAVA
ACKNOWLEDGMENT
We feel honour to express our most sincere
gratitude to our teacher MR.VENU GOPAL
whose untiring & guidance valuable
suggestion & gracious nature have made it
possible for us to submit our work without
any pain taking interest .

We completed our task with critical

analysis, knowledge full advices and constant
encouragement.

Our immense gratitude to all our team

members for their cheerful companionship
and valuable advice that have been great
helpful for our team.
 CONTENTS
 EXCHANGE RATE DETERMINATION
AND FORECASTING
 SETTNG TE EQUIIBRIUM SPOT

EXCHANGE RATE
 THEORIES OF EXCHANGE RATE

DETERMINATION
 EXCHANGE RATE FORECASTING
 INTRODUCTION OF FOREX
Question: What is the foreign exchange
market?

 The foreign exchange market is a market

for converting the currency of one country
into that of another country

Question: What is the exchange rate?

 The exchange rate is the rate at which one

currency is converted into another
NATURE: foreign exchange rate
 The foreign exchange market is a global network
of banks, brokers, and foreign exchange dealers
connected by electronic communications systems
 The market is always open somewhere in the
world

• If exchange rates quoted in different markets

were not essentially the same, there would be
an opportunity for arbitrage (the process of
buying a currency low and selling it high)

 Most transactions involve U.S. dollars on one side

• The U.S. dollar is a vehicle currency
INTRODUCTION: BASIC CONCEPT
Exchange Rate Determination
ACCORDING TO THE ECONOMIST: What
factors are important to future exchange
rates?

 Three factors that have an important

impact on future exchange rate
movements are
1.a country’s price inflation
2.a country’s interest rate
3.market psychology
 EXCHANGE RATE
MOVEMENTS
 An exchange rate measures the values of
one currency in units of another currency
 When a currency decline in values ,it is said
to depreciate .when it increases in values ,it
ts said to appreciate.
 On the days when some currencies
appreciate against a particular currency, that
currency is said to be “mixed in trading .”
 The percentage change (%^) in the value of
a foreign currency,is computed as St – St by
St – 1
where St denotes the spot rate at time t.
 CONTD..
•A positive %  represents appreciation of
the foreign currency, while a negative % 
represents depreciation.
 Annual Changes
in the Value of the Euro
Date Exchange Rate Annual
%
1/1/2000 $1.001/€ –
1/1/2001 $.94/€ – 6.1%
1/1/2002 $.89/€ – 5.3%
1/1/2003 $1.05/€ +18.0%
1/1/2004 $1.26/€ +20.0%
 AGENDA
 develop basic demand/supply model
for foreign exchange
 define effective rate of return, and
show how to compare returns on
assets priced in different currencies
 equilibrium: define and explore the
Covered Interest Parity condition
 see how money demand and
monetary policy influence rates of
return and exchange rates
BASIC CONCEPT: DEMAND
 Demand for foreign exchange
• to buy things denominated in it (goods,
services, or assets)
• to hold interest-bearing accounts in that
currency
• greater quantity demanded at lower
price/exchange rate
 Non-price Determinants of Demand.
• increased (decreased) demand for foreign G&S
 increased (decreased) domestic income
 lower (higher) relative price levels for G&S
denominated in currency
• increased (decreased) relative return on
assets denominated in foreign currency
BASIC CONCEPT: SUPPLY
 Supply of foreign exchange:
wanting to sell a currency
• greater quantity supplied at higher
price/exchange rate
 People wanting to sell more (less)
of a currency at any given XR is
an increase (decrease) in supply
• change in foreign income
• change in relative price levels
• change in relative rate of return on
domestic assets
 EXCHANGE RATE
EQUILIBRIUM
 An exchange rate represents the
price of a currency, which is
determined by the demand for that
currency relative to the supply for
that currency.
$$
$
 CONTD..
 The liquidity of a currency affects the
sensitivity of the exchange rate to specific
transactions.
 With many willing buyers and sellers, even
large transactions can be easily
accommodated.
 Conversely, illiquid currencies tend to
exhibit more volatile exchange rate
movements.
 Factors that Influence
Exchange Rates
e  f  INF , INT , INC , GC , EXP 

e = percentage change in the spot rate

 INF = change in the relative inflation
rate
 INT = change in the relative interest
rate
 INC = change in the relative income
level
 GC = change in government
controls
 EXP= change in expectations of
future exchange rates
 Factors that Influence
Exchange Rates
Relative Inflation Rates

$/£
U.S. inflation 
S0 U.S. demand for
British goods, and
r0 hence £.

 British desire for

D0
U.S. goods, and hence
the supply of £.
Quantity of £
 Factors that Influence
Exchange Rates
Relative Interest Rates
 A relatively high interest rate may

actually reflect expectations of

relatively high inflation, which may
discourage foreign investment.
 It is thus useful to consider the real

interest rate, which adjusts the

nominal interest rate for inflation.
 How Factors Can Affect Exchange
Rates
Trade-Related
Factors
U.S. demand for foreign
1. Inflation goods, i.e. demand for
Differential foreign currency
2. Income
Differential Foreign demand for U.S.
3. Govt Trade goods, i.e. supply of Exchange
Restrictions foreign currency rate
between
foreign
Financial U.S. demand for foreign currency
Factors securities, i.e. demand and the
1. Interest Rate for foreign currency dollar
Differential Foreign demand for U.S.
2. Capital Flow securities, i.e. supply of
Restrictions foreign currency
 Factors that Influence
Exchange Rates
Expectations
 Economic signals that affect

exchange rates can change quickly,

such that speculators may overreact
initially and then find that they have
to make a correction.
 Speculation on the currencies of

emerging markets can have a

substantial impact on their exchange
rates.
 Factors that Influence
Exchange Rates
Interaction of Factors
• The various factors sometimes
interact and simultaneously affect
exchange rate movements.
• For example, an increase in income
levels sometimes causes
expectations of higher interest rates,
thus placing opposing pressures on
foreign currency values.
 Speculating on
Anticipated Exchange Rates
• Many commercial banks attempt to
capitalize on their forecasts of
anticipated exchange rate
movements in the foreign exchange
market.
• The potential returns from foreign
currency speculation are high for
banks that have large borrowing
capacity.
 Speculating on
Anticipated Exchange Rates

 Exchange rates are very volatile,

and a poor forecast can result in a
large loss.
One well-known bank failure,
Franklin National Bank in 1974,
was primarily attributed to
massive speculative losses from
foreign currency positions.
 FOR EXAMPLE:
 The experience of the U.S. is the case in
point. U.S. dollar strengthened despite
growing current account deficits during
the 1981-85, 1990 and 2000. Foreign
capitals flowed into U.S. due to
• rising stock and real estimate prices,
• low inflation and relatively high real returns,
• low political risk
 CONTD…
 Exchange rate movements can be
subdivided into three periods:
• Day-to-day
• Short-term (several days to several
months)
• Long-term
SETTINGTHE EQUILIBRIUM
SPOT EXCHANGE RATE
SETTING THE EQUILIBRIUM

A. Exchange Rates
market-clearing prices that
equilibrate the quantities
supplied and demanded of
foreign currency.
 FOR EXAMPLE:
B. How Americans Purchase
German Goods
1. Foreign Currency Demand
-derived from the demand for
foreign country’s goods,
services, and financial
assets.
e.g. The demand for German
goods by Americans
B .Foreign Currency Supply
a. derived from the foreign
country’s demand for
local goods.
b. They must convert their
currency to purchase.
e.g. German demand for US
goods means Germans
convert DM to US $ in
order to buy.
Equilibrium Exchange Rates
3. Equilibrium Exchange Rate:
occurs when the quantity
supplied equals the quantity
demanded of a foreign
currency at a specific local price.
 Equilibrium Exchange Rates
C. How Exchange Rates Change
1. Increased demand
as more foreign goods are
demanded, the price of the foreign
currency in local currency increases
and vice versa.
Equilibrium Exchange Rates
2. Home Currency Depreciation
a. Foreign currency becomes
more valuable than the home
currency.
b. Conversely, the foreign
currency’s value has appreciated
against the home currency.
 Equilibrium Exchange Rates
3. Calculating a Depreciation:
Currency Depreciation

e0  e1 


where e1
e0 = old currency value
e1 = new currency value

Note: Resulting sign is always negative

Equilibrium Exchange Rates
Currency Appreciation

e1  e0

e0
Equilibrium Exchange Rates
D. FACTORS AFFECTING
EXCHANGE RATES:
1. Inflation rates
2. Interest rates
3. GNP growth rates
 EXPECTATIONS

I. WHAT AFFECTS A
CURRENCY’S VALUE?
A. Current events
B. Current supply
C. Demand flows
* D. Expectation of future
exchange rate
 CONTD…
III. Demand for Money and
Currency Values: Asset
Market Model
A. Exchange rates reflect the
supply of and demand for
foreign-currency
denominated assets.
 Exchange Rate Determination
Parity Conditions
1. Relative inflation rates
2. Relative interest rates
3. Forward exchange rates
4. Interest rate parity

Is there a well-developed Is there a sound and secure

and liquid money and capital Spot banking system in-place to support
market in that currency? currency trading activities?
Exchange
Rate

Asset Approach Balance of Payments

1. Relative interest rates
1. Current account balances
2. Prospects for economic growth
2. Portfolio investment
3. Supply & demand for assets
3. Foreign direct investment
4. Outlook for political stability
4. Exchange rate regimes
5. Speculation & liquidity
5. Official monetary reserves
6. Political risks & controls
 BASIC APPROACHES
• Balance of Payments
• Asset market
• Parity conditions

 These theories are not competing

theories but complimentary ones
THEORIES OF EXCHANGE
DETERMINATION
 PARITY CONDITIONS
 Meaning of Arbitrage:
It is simultaneous purchase and sale
of the same assets or commodities at the same
time on different markets to profit from price
discrepancies. Arbitrage also called as “Basis
Trading” is a process of making riskless profits by
exploiting price differences of identical or similar
financial instruments on different markets or in
different forms. Arbitrage exits as a result of
market inefficiencies and it provides a mechanism
to ensure prices do not deviate substantially from
fair value for long periods of time. A person who
engages in the process of arbitrage is called as
“Arbitrageur
 PARITY CONDITIONS (contd)
Conditions for Arbitrage:
 The same asset does not trade at the
same price on all markets i.e. there exists
No “Law of One price”.
 Two different substitutable assets will
identical cash flows do not trade at the
same price.
 An asset with the known price in the
future does not today trade at its future
price discounted at the risk free interest
rate.
 LAW OF ONE PRICE
 In competitive markets characterized by numerous buyers and sellers,
having low cost access to information, exchange adjusted Forward
Premium and Discount:
 prices of identical tradable goods and financial assets must be within
transition costs of equality worldwide.

 International arbitrageurs who follow the principle of “Buy low and sell
high” enforce the above rule of law of one price.

 A foreign currency is said to be at premium if forward rate expressed is

terms of home currency is greater than spot rate or else it is said to be at
discount.

 Annualized % of forward = FR – SR × 360

.
 Premium or Discount SR Forward contract period in
days
 ECONOMIC RELATIONSHIP
Economics condition under “law of one
price” & “parity theories”
 PURCHASE POWER PARITY (PPP)
 INTEREST RATE PARITY(IRP)
 FORWARD RATES AS UNBIASED
PREDICTORS OF FUTURE SPOT RATES
(UFSR)
 FISHER EFFECT (EF)
 INTERNATIONAL FISHER EFFECT(IFE)
PURCHASING POWER PARITY
[PPP]
 If international arbitrage enforces the law of one
price, then the exchange rate between the home
currency and domestic goods must be equal to
the exchange rate between home currency and
foreign goods.
 In other words, one unit of home currency
should have the same purchasing power
worldwide. Ex: - If a pen costs Rs 50 in India and
the same model pen costs $1 in US, then
exchange rate shall be $1 = Rs 50.
 For same purchasing power to remain constant
world wide, the foreign exchange rate must
change approximately the same as difference
between the domestic and foreign rates of
inflation
 ASSUMPTION OF PPP
 The financial markets are perfectly liquid,
transparent and free with no controls,
taxes, transaction costs etc.
 Goods markets are perfect, with
international shipment of goods able to
take place freely, instantaneously and
without any cost.
 There is a single consumption goods
common to everyone.
 The same commodities appear in the
same proportions in each country’s
consumption basket.
 2 VERSION OF PPP
I.ABSOLUTE VERSION

P Purchasing power parity in its absolute version
states that price levels should be same world
wide when expressed in common currency.
 A unit of home currency should have the same
purchasing power worldwide.
 This theory is application of law of one price to
national price levels or else arbitrage
opportunities would exist.
 However, absolute PPP ignores the effects of
transportation costs, tariffs quotas and other
restrictions and product differentiations in free
trade.
 II.RELATIVE VERSION
 The relative version of PPP states that the
exchange rate between the home currency
and foreign currency will adjust to reflect
changes in the price levels of two
countries.
 Ex: - If inflation in India is 10 % and in US
is 3% then the rupee value of the USD
must rise by about 7 % to equalize the
Rupee price of goods in both the countries.
 REAL EXCHANGE RATE
 The real exchange rate is the nominal exchange rate adjusted for changes
in the relative purchasing power of each currency since some base period

 ét = et × Pf BY Ph

 By indexing these price levels to 100 as of the base period their ratio
reflects the change in the relative purchasing power of these currencies
since time 0. Increase in foreign price level and foreign currency
depreciation have offsetting effects on the real exchange rate and similarly
home price level increases and foreign currency appreciation offset each
other.
 An alternative way to represent the real exchange rate is to directly
reflects the change in relative purchasing powers of these currencies by
adjusting the nominal exchange rate for inflation in both countries since
time 0 (base period).
 ét = et × (1 + ih)t
(1 + if)t
 Note: - et shall be in direct quote.
 INTEREST RATE PARITY
THEORY [IRP]
 According to IRP theory, the interest differential should be
equal to the forward differential i.e. the currency of the
country with a lower interest rate should be at a forward
premium in terms of the currency of the country with
higher interest rate. If the above condition is satisfied, the
forward rate is said to be at interest rate parity and
equilibrium prevails in money market.
 Covered Interest Differential:
 Interest parity ensures that the return on a hedged or
covered foreign investment will just equal the domestic
interest rate on investment of identical risk or else it gives
rise to covered interest arbitrage. The process of covered
interest arbitrage continues until interest parity holds,
unless there is government interference.
 Balance of Payments (Flows)
Approach
 Essentially BOP approach says equilibrium
exchange rate is achieved when current account
inflows match current account outflows
 BOP transactions are widely appealing, captured,
and reported
 Criticism of the BOP approach is that it focuses on
flows rather than stocks of money or financial
assets
 Relative stocks of money or financial assets do
not play a role in the theory
 Practitioners use BOP but academics largely
dismiss it
 Asset Market Approach
 AKA relative price of bonds or portfolio
balance approach
 argues that exchange rates are
determined by supply and demand for a
wide variety of assets
• Shifts in supply and demand alter exchange
rates
• Changes in monetary and fiscal policy alter
expectations and thus exchange rates
• Theories of currency substitution follow the
same basis premises of portfolio rebalance
framework
 CONTD

• 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 (as per the previous exhibit)
• In highly developed countries, foreign investors are
willing to hold securities and undertake foreign direct
investment based primarily on relative real interest
rates and the outlook for economic growth and
profitability
 The Asset Market Approach to
Forecasting
 The asset market approach assumes that
whether foreigners are willing to hold claims
in monetary form depends on an extensive
set of investment considerations:
• Relative real interest rates
• Prospects for economic growth
• Capital market liquidity
• A country’s economic and social
infrastructure
• Political safety
• Corporate governance practices
• Contagion (spread of a crisis within a
region)
• Speculation
 Forecasting in Practice
 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.
 Forecasting in Practice
 Numerous foreign exchange
forecasting services exist, many of
which are provided by banks and
independent consultants.
 Some multinational firms have their
own in-house forecasting
capabilities.
 Predictions can be based on
elaborate econometric models,
technical analysis of charts & trends.
 CONTD….
 The usefulness of the forecasting
services depends on the motive
for forecasting and the required
accuracy of the forecast.
THANK YOU