International Investment 2

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International Investment 2

  1. 1. LUBS5052 International Investment<br />Charlie X. Cai<br />WWW. CharlieXCai.info<br />
  2. 2. Exchange Rate Determination & Forecasting<br />Session 2<br />
  3. 3. Agenda<br />The international parity relations<br />The determinants of exchange rates in the short run & the long run<br />The Exchange Rate Regimes<br />Methodologies and models employed in exchange rate forecasting.<br />
  4. 4. 1. The international parity relations<br />
  5. 5. 2 - 5<br />Parity Relations<br />The purchasing power parity relation, linking spot exchange rates and inflation.<br />The International Fisher relation, linking interest rates and expected inflation.<br />The uncovered interest rate parity relation, linking spot exchange rates, expected exchange rates and interest rates.<br />The foreign exchange expectation relation, linking forward exchange rates and expected spot exchange rates.<br />See Handout 1, No. 1<br />
  6. 6. Summary of Parity Relations<br />
  7. 7. 2 - 7<br />Exhibit 2.3: International Parity Relations Linear Approximation<br />Foreign exchange expectation<br />PPP<br />Interest rate parity<br />International Fisher relation<br />
  8. 8. PPP<br />Poor explanation of short term exchange rates: Implies real returns for investors of different countries DO differ.<br />Definition of inflation<br />Transfer costs, import taxes, export subsidies<br />Recent research shows that exchange rates revert to PPP values in the long run (e.g. Grossman & Rogoff (1995)) - Large deviations from PPP cannot continue forever<br />
  9. 9. Intl. Fisher Relation<br />Earlier studies found support for the model for major currencies (e.g. Kane & Rosenthal 1974 – 1979)<br />Later studies (post 1979) indicate that real rates variable over time & across countries<br />Problems with measuring real rate since requires measure of expected inflation.<br />
  10. 10. FOREX expectations<br />Regression (expected) ex. rate movement against forward discount premium (or equivalently interest rate differential) observed at start of period:<br />[(S(t+1) – St)/ St] =  + [(Ft - S0)/S0] + <br />Problems measuring E(S1), and in practice ex post S1 substituted.<br />R2 usually low and  sometimes negative (it should be 1)<br />Explanations:<br />Exchange rates are unpredictable<br />A time varying risk premium should be included in the relationship.<br />
  11. 11. Interest rate parity<br />Where markets are free & unregulated this relation MUST hold, within transaction costs<br />For certain currencies deviations from interest rate parity can be quite large:<br />Many developing countries impose various forms of capital controls & taxes which impede arbitrage<br />Some smaller currencies can only be borrowed or lent domestically & carry considerable political risk<br />
  12. 12. Lessons from international money markets<br />Exchange rates do not neutralise inflation differentials in real terms<br />Exchange rates do not correct interest rate differences between two currencies<br />International investors are faced with currency risk, although over the long run mean reversion reduces this risk.<br />Portfolio performance can be improved by correctly forecasting exchange rates.<br />International asset pricing models need to incorporate exchange risk<br />
  13. 13. 2. Determining exchange rates<br />
  14. 14. What affects exchange rates?<br />Differences in national inflation rates<br />Changes in real interest rates<br />Differences in economic performance<br />Changes in investment climate<br />Government monetary policy<br />Government fiscal policy<br />
  15. 15. Value based on absolute PPP<br />Compare prices of goods in two countries<br />Does the exchange rate conform to absolute PPP, or is it undervalued or overvalued?<br />Example:<br />A Big Mac costs 2600 wons in Seoul & 2.56$ in the US. The current exchange rate is 1,474 wons/$. Is the South Korean currency under/over valued relative to the USD?<br />Exchange rate implied by Big Mac assuming law of one price = 2600wons/2.56$ or 1015.625wons/1$. The won is undervalued by (1015.625/1474) – 1% = -31%<br />See Exhibit 3.1, Solnik, page 61<br />
  16. 16. Value based on relative PPP<br />Method:<br />Select an inflation index for each country<br />Select an historical period for which to compute the long run PPP<br />Determine the fundamental value of the exchange rate and any under/over valuation<br />Problems:<br />Selecting an inflation index<br />The base date selected will give different conclusions <br />
  17. 17. Summary of PPP approach<br />PPP should help explain future movements in exchange rate<br />Exchange rates can become very misaligned & stay so<br />Additional models are required to determine exchange rate movements<br />
  18. 18. Balance of Payments Approach<br />See No. 1, Handout 2.<br />1. Trade flows under capital restrictions:<br />(a) Is there a trade balance deficit?<br />(b) How will imports & exports react to an exchange rate adjustment?<br />2. Financial flows:<br />Do financial flows cover any current account deficit?<br />3. Web exercise: <br />Source of information on BOP<br />
  19. 19. The Asset Market Approach<br />Exchange rates are asset prices traded in an efficient market.<br />The exchange rate is determined by the relative willingness to hold each currency<br />The exchange rate is determined by expectations about the future, and not by current trade flows.<br />Requires that news that should affect ex. rate be specified and its influence be quantified a priori.<br />Short term view<br />News traders Sites:<br />
  20. 20. 3. Exchange Rate Regimes<br />
  21. 21. 2 - 21<br />Exchange Rate Regimes<br />Historically, there have been three different regimes:<br />Flexible (or Floating) Exchange Rates<br />Fixed Exchange Rates<br />Pegged Exchange Rates<br />
  22. 22. 2 - 22<br />Flexible (Floating) Exchange Rate Regime<br />One in which the exchange rate between two currencies fluctuates freely in the foreign exchange market.<br />Advantage<br />The exchange rate is a market-determined price that reflects economic fundamentals at each point in time.<br />Governments are free to adopt independent domestic monetary and fiscal policies.<br />Disadvantage<br />Quite volatile exchange rates.<br />
  23. 23. Fixed Exchange Rate Regime<br />One in which the exchange rate between two currencies remains fixed at a preset level, known as official parity.<br />Advantages:<br />Eliminates exchange rate risk, at least in the short run.<br />Brings discipline to government policies.<br />Disadvantages:<br />Deprives the country of any monetary independence.<br />Also constrains country’s fiscal policy.<br />Its long-term credibility<br />
  24. 24. 2 - 24<br />Currency Board<br />Today some countries try to maintain a fixed exchange rate regime against the dollar or euro.<br />This is done through a “currency board”<br />The supply of home currency is fully backed by an equivalent amount of that major currency.<br />
  25. 25. Question<br />Has Hong Kong formally adopted a currency board?<br />
  26. 26. 3 - 26<br />Answer<br />Hong Kong did not formally adopt a currency board. Instead, it announced a total commitment to maintain a parity of the HK dollar with the U.S. dollar within the band of 7.75 – 7.85 HK$/U.S$. <br />The Hong Kong Monetary Authority stands ready to use its reserves to defend the fixed rate, despite pressures brought by the appreciation of the Chinese RMB (yuan).<br />
  27. 27. 2 - 27<br />Pegged Exchange Rate Regime <br />Characterized as a compromise between a flexible and a fixed exchange rate.<br />The exchange rate is allowed to fluctuate within a (small) band around a target exchange rate (“peg”) and the target exchange rate is periodically revised to reflect changes in economic fundamentals.<br />Advantages<br />Reduces exchange rate volatility in the short run.<br />Also encourages monetary discipline for the home country.<br />Disadvantage<br />Can induce destabilizing speculation.<br />
  28. 28. Problems with pegged exchange rates<br />In a pegged system the exchange rate remains constant provided credibility & confidence in fundamentals maintained.<br />Where adjustments do occur they tend to be large, since the country has been committed to defending a preset exchange rate level.<br />In the long run the exchange rate must reflect fundamentals.<br />
  29. 29. 3 - 29<br />International Monetary Arrangements<br />The international monetary system evolved through three stages:<br />Gold standard<br />Pegged exchange rate<br />Freely floating exchange rates<br />The current situation is one of floating exchange rates and in some parts of the world, a pegged exchange rate.<br />
  30. 30. Currency Crises<br />A widening current a/c deficit used to be offset by a capital a/c surplus (under a booming economy), but prospects for growth less thus investment less<br />Country draws on its reserves & sets off speculation<br />Interest rates are raised to attract capital but high interest rates hurt the economy causing further slow down in growth<br />Capital control measures are put in place. The IMF provides additional reserves<br />Markets pessimistic and devaluation is required<br />Currency devaluation may cause increased inflation and lead to further depreciation.<br />
  31. 31. 4. Forecasting methodologies & models<br />
  32. 32. 3 - 32<br />Exchange Rate Forecasting<br />Two methods are used to actively forecast exchange rates:<br />Economic Analysis<br />Technical Analysis<br />Economic analysis is the usual approach for assessing the fair value, present and future, of foreign exchange rates.<br />However, it is often argued that technical analysis may better explain short-run fluctuations in exchange rates.<br />
  33. 33. 3 - 33<br />The Econometric Approach<br />Econometric models make it feasible to take complex correlations between variables into account explicitly.<br />Parameters for the model are drawn from historical data.<br />Current and expected values for causative variables are entered into the model, producing forecasts for exchange rates.<br />
  34. 34. Forecasting Models<br />Traditional<br />Time varying expected return: ARIMA<br />Time varying expected return: Information variables<br />Time varying variances: GARCH<br />Non traditional<br />Chaos Theory<br />Artificial intelligence, expert systems, neural networks<br />See Solnik, Chapter 3, Appendix<br />
  35. 35. 3 - 35<br />The Econometric Approach<br />These models have two drawbacks:<br />most rely on predictions for certain key variables (money supply, interest rates) that are not easy to forecast.<br />The structural correlation estimated by the parameters of the equation can change over time.<br />
  36. 36. 3 - 36<br />Technical Analysis<br />Bases predictions solely on price information.<br />Technical analysis looks for the repetition of specific price patterns.<br />Once the start of such a pattern has been detected, it automatically suggests what the short-run behavior of an exchange rate will be.<br />Technical analysis has long been applied to commodity and stock markets.<br />The application to the foreign exchange market is a more recent phenomenon.<br />
  37. 37. Technical Analysis<br />Moving averages<br />The aim is to smooth erratic daily swings of exchange rates in order to signal major trends.<br />Filter rule<br />buy signals when an exchange rate rises X percent (the filter) above its most recent trough<br />sell signals when it falls X percent below the previous peak.<br />Index of market momentum<br />
  38. 38. Central Bank Intervention<br />Major players in the foreign exchange markets.<br />Their motives are somewhat different from those of most other market participants. <br />Some central banks are renowned for the active management of their foreign currency reserves, but most do not attempt to profit from trading.<br />Central banks try to implement the monetary policy and exchange rate targets defined by their monetary authorities.<br />
  39. 39. 3 - 39<br />Exhibit 3.5 An Example of the Impact of News about Central Bank Intervention<br />
  40. 40. Performance of Forecasts<br />Different measures of forecasting ability can be used and the track record of forecasters shows the difficulty of the task.<br />The type of method used to forecast exchange rates depends on the user’s motivation.<br />A currency hedge focuses on short term movements, while an international asset allocator cares about long-term prospects.<br />
  41. 41. Use of Forecasts<br />The corporate treasurer who manages a complex international position with daily cash flows and adjustments in his foreign exposure can respond readily to technical analysis recommendations. <br />This is not the case for money managers who tend to use economic models for their asset allocation.<br />Money managers use technical analysis of currencies mainly for timing their investment sales and purchases or for currency-hedging decisions using derivatives.<br />
  42. 42. Exercises from Solnik<br />Chapter 2: Qus1, 2, 4, 7, 8, 9, 12 ,14<br />Chapter 3: Qus. 1, 9, 2, 8, 10 <br />
  43. 43. Web Exercise<br />PPP between US$ and GBP<br />1980-2006<br />1980-1990<br />1990-2000<br />2000-2006<br />Balance of Payments<br />Source of information. Latest number for US, UK, Euro, JP, and your home country.<br />
  44. 44. http://www.newyorkfed.org/markets/foreignex.html<br />http://www.imf.org/external/pubs/ft/weo/2007/02/weodata/index.aspx<br />http://www.bea.gov/International/Index.htm<br />
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