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Lecture 18 foreign exchange and exposure rate

Lecture 18 foreign exchange and exposure rate






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    Lecture 18 foreign exchange and exposure rate Lecture 18 foreign exchange and exposure rate Document Transcript

    • RU/SAMS/IFM/ANSLesson 18: Structural Models ForForeign Exchange and Exposure RateLearning objectives: To discuss with you at some length some of conventional as well as newly developed and structured models of exchange rate determination. To guide you to use these models for exchange rate forecasting.Exchange rate theory has occupied some of the best minds in the economics professionduring the last couple of decades. At one end of the spectrum there are relatively simpleflow models the view exchange rate as the outcome of the equilibrium between flowdemands and flow supplies of foreign exchange arising out of imports and exports. At theother extreme there are very sophisticated (and complicated asset market models, whichfocus on investor expectations and risk –return preferences, which govern their assetallocation decisions. Exchange rate theory presents the student with a vast andbewildering menu to choose from. Some attempts have been made to synthesize thevarious partial models into a comprehensive account of exchange rate determination.Different models of exchange rates differ in the emphasis they put on the differentcomponents of demand for and supply of a currency. Early theories, proposed anddeveloped in the days when cross-border capita lows were rather small emphasizedemand and supply arising out of current account transaction viz. imports and exports ofgoods and services. Later, as restriction on capital flows were gradually eliminated, itbecame obvious that at least the short-run behavior of exchange rates is dominated bycapital account transactions, that is asset allocation and portfolio reshuffling byinternational investors, More recent theories of exchange rate behavior therefore havetended to emphasize the view of exchange roes ass prices of assets denominated indifferent currencies which equilibrate asset demands and supplies.The need to integrate the two approaches has been recognized. After all, just as incomestatements of a firm is linked to the balance sheet, balance of payment surpluses anddeficits alter distribution of wealth and hence influence asset demands and supplies in theling run. Attempts at synthesis have been directed at taking account of this link.Flow Models of exchange Rate DeterminationA simple model of exchange rate determination with floating rates is depicted in figures1,2 and 3.Figure 1 shows the equilibrium in the Euro/$ market. He demand for dollars arises fromimports of goods and services from US into Europe. The supply curve arises from Eurozone exports to the US. The figure shows the case when the elasticity of demand forEuropean goods in US is greater than unity. Figures 2 and 3 show the case when it is lessthan unity. The former yields a stable equilibrium while; the latter may lead to an unstableequilibrium. It must be pointed out hear that not all flows on current account arise out ofexport and imports. Interest payments and receipts on foreign liabilities and assets belongto current account but do not depend upon current exchange rate. Similarly items likeunilateral transfers also do not depend upon exchange rate. Flows arising on this accountmust be added to the flows arising out of merchandise trade. 97
    • RU/SAMS/IFM/ANS D SExchange rateEUR/$E S D Fig 1. No. Of Dollars B S D SExchange ExchangeRate EUR/$ Rate EUR/$ E E S D S D No. Of Dollars No. Of Dollars Fig 2 Fig 3The main difficulty with this account of exchange rate determination is its total neglect ofcapital account. Also, being a static model it neither allows for lags nor for influences ofexpectations on exchange rate. The well-known Mundell – Fleming model attempts to correct the first ofthese omissions by including capital flows. Capital flows are viewed as depending uponthe interest rate differential between the home country and the rest of the world. Thedomestic economy assumed to be characterized by Keynesian unemployment so thatoutput can be expanded at fixed price. The model then determines the exchange rate andthe interest rate to achieve simultaneous equilibrium in the goods market, the moneymarket, and the balance of payments (current plus capital account). The model representsextension of the conventional US –LM analysis to an open economy.Asset Market ModelsIn contrast to flow equilibrium models, asset market approach to exchange ratedetermination, which gained prominence in the late 1970s stresses that the equilibriumexchange rate is that rate at which the market as a whole is willing to hold the givenstocks of assets denominated in different currencies. The foreign exchange market in this 98
    • RU/SAMS/IFM/ANSview must be treated like any other highly organized market for financial assets such asthe stock market of the bond market. The asset market approach has given rise to a variety of formulations. Wewill look at three important models, which by now have become part of the receivedwisdom in exchange, rate economics.The Current Account Monetary ModelThis approach to exchange rate determination is a reformulation of the famous monetaryapproach to a balance of payments, which originated at the university of Chicago in theearly seventies and, for some time, was the official creed espoused by the IMF. Thecentral ideas of a simple version of this approach can be summarized as follows: There is only one asset, viz. money, domestic money is held only by domestic residents and foreign money by foreign residents. Purchasing power parity holds. The foreign price level is exogenous (home country is “small”). In other words, development in the home country has no effect on the price level in the foreign country. In each country there is a stable demand – for – money function. This means that demand for real money balances depends upon a few variables like real income and nominal interest rate and the parameters of this relationship do not fluctuate over time. Foreign real income and interest rate are exogenous. Fully flexible exchange rates keep balance of payment in continuous equilibrium. Consequently there is no change in foreign exchange reserves. Nominal money supply is therefore determined entirely by domestic credit creation, which is totally under the control of monetary authorities.Capital Account Monetary ModelThe assumption of PPP even in the short run as the counterintuitive prediction about theeffect of interest rate changes on exchange on exchange rate have often been carried asserious weakness of the current account monetary model. Extensions of the monetarymodel allow for short run departures from PPP and attempt to distinguish between thosechanges in interest rate, which only compensative for changes UN inflationaryexpectations, and those, which are due to changes in monetary tightness. The short –run"stickiness" of goods prices can produce what is known as "overshooting" of exhaust ratebeyond its long-run equilibrium value.We will describe here a model along these lines due to Frankel (1979) PPP holds in the long-run There is a stable demand for money function in each country. Uncovered interest parity and the Fisher open conditions hold. Expected change in the exchange rate in the short run depends upon perceived departures from long run equilibrium exchange rate and expected inflation differentials. 99
    • RU/SAMS/IFM/ANSPortfolio Balance ModelsThe monetary approach ignores all other "assets "except money it is implicitly assumedthat markets for domestic and foreign bonds always clear. The assumption of UIP impliesthat domestic and foreign bonds are regarded as perfect substitutes by the investors inboth the countries. In contrast, portfolio balance models recognize first, that asset choicemust be modeled as portfolio diversification problem, that is, given total wealth, investorsdivide it between various assets--domestic and foreign money, domestic-and foreignbonds-based on their expected returns and, second, that assets denominate in differentcurrencies are not perfect substitutes. A non-zero risk premium will generally exist infavour of (or against a currency) so that DIP does not hold full blown versions of theportfolio balance model also take account of the link between current account balance andasset demands.The various versions of the portfolio balance theories of exchange rate utilize the well-known mean variance portfolio selection framework. Risk-averse investors diversify theirportfolios across the available assets so that risk-adjusted return is equalized betweendifferent assets. The key is to recognize that in -a well diversified portfolio, an assetscontribution- to portfolio risk depends upon the covariance of its return with the portfolioreturn. Hence the proportion of total wealth invested in a particular risky asset dependsupon its expected return and its covariance with portfolio return. The technical details ofthe mean-variance approach can be’ found in the appendix to this chapter. As the supplyof an asset changes, its expected return is altered as investors reshuffle their portfolios.This leads to changes in demands for individual assets and, given their supplies, changesin their prices.Expectation ModelAlthough currency values are affected by current events and current supply and demandflows in the foreign exchange market. They also depend on expectations about futureexchange rate movements. And exchange rate expectations are influenced by everyconceivable economic, political, and social factor.The role of expectations in determining exchange rates depends on the fact that currenciesare financial assets and that an exchange rate is simply the relative price of two, financialassets-one countrys currency in teams of anothers. Thus, currency prices are determinedin the same manner that the prices of assets such as stocks, bonds, gold, or real estate aredetermined. Unlike the prices of services or products with short storage lives, asset pricesare influenced comparatively little by current events. Rather, they are determined bypeoples willingness to hold the existing quantities of assets, which in turn depends ontheir expectations of the future worth of these assets. Thus, for example, frost in Floridacan bump up the price of oranges, but it should have little impact on the price of the citrusgroves producing the oranges; instead, longer-term expectations of the demand andsupply of oranges governs the values of these groves. Similarly, the value today of a given currency, say, the dollar, depends on whetheror not-and how strongly-people still want the amount of dollars and dollar-denominatedassets they held yesterday. According to this view-known as the asset market model of 100
    • RU/SAMS/IFM/ANSexchange rate determination--the exchange rate between two currencies represents theprice that just balances the relative supplies of and demands for, assets denominated inthose currencies. Consequently, shifts in preferences can lead to massive shifts incurrency values.The Nature of Money and Currency ValuesTo understand the factors that affect currency values, it helps to examine the specialcharacter of money. To begin, money has value because people are willing to accept it inexchange for goods and services. The value of money, therefore, depends on itspurchasing power. Money also provides liquidity that is you can readily exchange it forgoods or other assets, thereby facilitating economic transactions. Thus, money representsboth a store of Glue and a store of liquidity. The demand for money therefore depends onmoneys ability to maintain its value and on the level, of economic activity. Hence, thelower the expected inflation rate, the more money people with demand. Similarly, highereconomic growth means more transactions and a greater demand for money to pay bills.The demand for money is also affected by the demand for assets denominated in thatcurrency. The higher the expected real return and the lower the riskiness of a countrysassets, the greater is the demand for its currency to buy those assets. In addition, as peoplewho prefer assets denominated III that currency (usually residents of the country)accumulate wealth, the value of the currency rises. Because the exchange rate reflects the relative demands for two moneys, factorsthat increase the demand for the home currency should also increase the price of homecurrency on the foreign exchange market. In summary, the economic factors that affect acurrencys value include its usefulness as a store of value, detem1ined by its expected rateof inflation: the demand for liquidity, detonated by the volume of transactions in thatcurrency; and the demand for assets denominated in that currency, detem1ined by therisk-return pattern on investment in that nation’s economy and by the wealth of itsresidents. The first factor depends primarily on [he country’s future monetary policy,while the latter two factors depend largely on expected economic growth and political andeconomic stability, All three factors ultimately depend on the soundness of the nationseconomic policies. The sounder these policies, the more valuable the nations currencywill be; conversely, the more uncertain a nations future economic and political course,the riskier its assets will be, and the more depressed and volatile its currencys value.Critics who point to the links between the huge U.S. budget deficits, high real interestrates, and the strong dollar in the early 1980s challenge the asset market view that soundeconomic policies strengthen a currency. But others find this argument unconvincing,especially now that the dollar has fallen while the deficit has risen further. If the bigdeficits were responsible for high real U.S. interest rates, there would be more evidencethat private borrowing was being crowded out in interest-sensitive areas, such as fixedbusiness investment and residential construction. Yet the rise in real interest ratescoincided with rapid growth in capital spending.An alternative explanation for high real interest rates is that a vigorous U.S. economy,combined with a major cut in business taxes in 1981, raised the after-tax profitability ofbusiness investments. The result was a capital spending boom and a strong dollar.Indeed, if large government deficits and excessive government borrowing cause CUTcurrencies to strengthen, then the Argentine austral and Brazilian cruzeiro should be 101
    • RU/SAMS/IFM/ANSamong the strongest currencies in the world. Instead they are among the weakestcurrencies since their flawed economic policies scare off potential investors. 102