Theories of Exchange rate determination

INTRODUCTION By definition, the Foreign Exchange Market is a market1 in which different currencies can be exchanged at a specific rate called the foreign exchange rate. We can anticipate the huge importance of the foreign exchange rate if we can just consider the influence of it on the imports and exports of a country. For example, lets assume a currency appreciation2 - the euro against the US dollar. Firstly, the exports of the European Union (E.U) nations will become expensive for the United States of America (USA), which among other things means that E.U product will lose in terms of competitiveness. Secondly, such a currency appreciation will be to the benefit of E.U imports, should those be payable in US dollars. Conversely, a depreciation3 of the euro against the US dollar will cause an opposite impact. On the other hand, the rapid growth of international trade (both the import penetration4 and the export ratio5) during the last decades, which was mainly due to the increase of the open economies, enhances the significance of the foreign exchange rates. VOLATILITY AND RISK Undoubtedly, dramatic movements in the value of currencies can occur where the forces of supply and demand freely determine the price. Consequently, such a system increases the exchange rate risk associated with but not limited to international transactions. The cross-border financial activity differs from the domestic activity in respect to related risk due to the fact that when investing in a foreign country you have to consider many other factors, such as: Tax system - differences related to the specific countrys system. Political risk - a democratic country is preferable to a non-democratic one. Government intervention - it is also preferable to deal with a country without government intervention. Business risk - unforeseen changes in the general economic environment. In addition, the likely volatility in the exchange rate can drastically affect the cost, profits and return on investments of international firms, thus, resulting in the following levels of risk: Economic exposure o Transaction exposure is related to those activities that trade internationally. For example, a EU company imports bicycle components from the United States with 2 months credit. Possible US dollar depreciation will be for the benefit of the EU organization because it will pay fewer euros. On the contrary, if the US dollar appreciates, the company will suffer a loss, due to the fact that it will pay more euros. The transaction exposure (the risk of adverse movements in the exchange rate) can be eliminated using hedging instruments. An example of this would be forward rate contracts. o Operational exposure. Although a company may not trade globally, due to competitiveness, it may suffer the exchange rate risk. For example, a US

bicycle producer will have a competitive advantage compared to a EU producer of a similar type of bicycle if the euro depreciates against the US dollar. The price of the US bicycle if converted into euros will fall, and consequently will attract EU members to buy it.

Translation exposure Assuming a company that has a subsidiary outside the EU and expects profits in one years time. Based on the current exchange rate between foreign and domestic currency, the company has converted the amount of profits in its local currency. If the euro appreciates against the local currency, then the amount of profits when converted into euros will be less. DETERMINANTS OF EXCHANGE RATE Many theories there have been written in respect to the main determinant of future exchange rates. Although the majority of these theories give adequate reasons in order to explain what actually determines the rates between the currencies, we can argue that there are many factors that may cause a currency fluctuation. Consequently, there is little that can be alleged in respect to the theory that better answers the question of what finally determines the exchange rates. Here below, we will refer to the main theories regarding the determinants of the exchange rates. 1. Supply and Demand As stated earlier, the exchange rate, just like commodities, determines its price responding to the forces of supply and demand8. Therefore, if for some reason people increase their demand9 (shift of the curve from D to D1) for a specific currency, then the price will rise from A to B, provided the supply remains stable. On the contrary, if the supply10 is increased (shift of the curve from S to S1), the price will decline from A to C, provided the demand remains stable (figure P1).

Any excess supply (above the equilibrium point) or excess demand (below the equilibrium point) will increase or decrease temporarily foreign currency reserves accordingly. Finally, such disequilibrium situations will be eliminated through the pricing,

e.g. the market itself. 2. Purchasing Power Parity (PPP) By definition the PPP states that using a unit of a currency, let us say one euro, which is the purchasing power that can purchase the same goods worldwide. The theory is based on the law of one price, which argues that should a euro price of a good be multiplied by the exchange rate ( /US$) then it will result in an equal price of the good in US dollars. In other words, if we assume that the exchange rate between the and US $ states at 1/1.2, then goods that cost 10 in the EU should cost US$ 12 in the United States. Otherwise, arbitrage11 profits will occur. However, it is finally the market that through supply and demand will force accordingly the euro and US dollar prices to the equilibrium point. Thus, the law of one price will be reinstated, as well as the purchase power parity between the euro and US dollar. Inflation differentials between countries will also be eliminated in terms of their effect on the prices of the goods because the PPP will adjust to equal the ratio of their price levels 12. More specifically, as stated in their book (Lumby S. & Jones C. 1999) the currency of the country with the higher rate of inflation will depreciate against the other countrys currency by approximately the inflation deferential. In conclusion, it can be argued that the theory, although it describes in a sufficient way the determination of the exchange rates, is not of good value, mainly because of the following two disadvantages. Firstly, not all goods are traded internationally (for example, buildings) and secondly, the transportation cost should represent a small amount of the goods worth. 3. The Balance of Payments (BOP) Approach The balance of payments approach is another method that explains what the factors are that determine the supply and demand curves of a countrys currency. As it is known from macroeconomics, the balance of payments is a method of recording all the international monetary transactions of a country during a specific period of time. The transactions recorded are divided into three categories: the current account transactions13, the capital account transactions14, and the central bank transactions15. The aforementioned categories can show a deficit or a surplus, but theoretically the overall payments (the BOP as a whole) should be zero which rarely happens. As stated earlier, a currencys price depreciation or appreciation (the change in the value of money), directly affects the volume of a countrys imports and exports and, consequently, a likely fluctuation in the exchange rates can add to BOP discrepancies. For example, a likely depreciation will increase the value of exports in home currency terms (the larger the exports demand elasticity the greater the increase). Conversely, the imports will become more expensive and their value will be reduced in home currency (the larger the imports demand elasticity the greater the decrease). Consequently, we can argue that unless the value of exports increases less than the value of imports, the depreciation will improve the current account. More specifically, we can finally assess the impact of the currencys depreciation on the current account only by considering the price sensitivity of imports and exports. The Marshall Lerner Condition shows that if the sum of the price elasticity of demand for imports and exports is greater than one, then a fall in the exchange rate will improve

the current account of BOP. Hx + Hm > 1 Hx: Price elasticity of exports volumes Hm: Price elasticity of import volumes The J curve effect illustrates that in the short-term a depreciation of the currency can initially worsen (from A to B) the current account balance before it improves its position (figure P2). This is due to the low price elasticity of demand for imports and exports in the immediate outcome of an exchange rate change.

4. The Monetary Approach In this approach attention is given to the stock of currencies in comparison to the willingness of people to hold these stocks. According to the monetary theory, exchange rates adjust to ensure that the quantity of money in each currency supplied is equal to the quantity demanded (Parkin M. & King D. 1992). Both Quantity Theory of Money (QTM) and Purchasing Power Parity (PPP) have been used in support of the aforementioned theory. The QTM states that there is a direct relationship between the quantity of money and the level of prices of goods and services sold (Investopedia.com). In other words, more money equals more inflation. In a domestic framework, the following equation has been formulated16. MV = PY
M: Money supply/demand V: Velocity of circulation (the number of times money change hands) P: Average price levels Y: GDP

Finally, we can conclude that an increase in the money supply leads to inflation, which in turn results in the decrease in the value of money or purchasing power. Consequently, if we also consider this in an international context, we will appreciate the following implications: Firstly, a rapid increase in the money supply (in the home currency), which as stated

earlier means inflation, will put into effect the PPP resulting in the depreciation of the currencys exchange rate. Secondly, a higher interest rate will also result in the currencys depreciation because of the positive relationship between interest rates and money circulation. Finally, if the GDP grows faster than overseas GDP, the demand for money will increase. Assuming there is a given supply of money, the exchanged rate will decrease, which is in direct contrast to the PPP approach. 5. The Portfolio Balance Approach The portfolio balance approach takes into consideration the diversification of investors portfolio assets. Diversification is a technique that attempts to reduce risk by investing both among various financial instruments and across national borders, to mention just a few. For example, here below we consider a combination of domestic and foreign money and domestic and foreign bonds, the implications of which are illustrated in the following figure P3. Figure P3. Portfolio balance approach

Both the M and the B lines show combinations of domestic interest rates and exchange rates. The upward line M is in agreement with the equilibrium in the money market and the downward line B is in agreement with the equilibrium in the bond market. Point E, which is the intersection of M with B, represents the combination of interest rate with the exchange rate that gives equilibrium to both the money and bond markets. What the theory argues is that an increase in the money supply will lead to a depreciation of the exchange rate. The extent of the depreciation depends upon the slope of the curves M and B. For example, if we consider an increase in the domestic money supply, we will anticipate that a lower interest rate and /or a higher exchange rate can only absorb the excess supply, which in turn will result in the reduction of bonds. To this end, line M will move to the right and line B will move to the left. EXCHANGE RATE FORECASTING

In the previous section we referred to various theories in respect to the main determinant of future exchange rates. However, it is actually an empirical topic to identify the most important factors. As a result, we can argue that forecasting exchange rates is a difficult task because of so many factors that might be regarded as determinants. In addition, using formulas 17 (similar to the Interest Rate Parity Theorem) will result in only imprecise estimates of future currencies exchange, basically because the data related to inflation differentials and future spot rates are by themselves only estimates (Lumby S. & Jones C. 1999). On the other hand, it remains doubtful weather or not the foreign exchange market is an efficient18 one - since it seems that not all information but only the historical is incorporated in prices (weak form efficiency). Although we share the opinion that there is no reliable method available to forecast exchange rates, we will refer here below to some of the main concepts. 1. 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. These drivers include the following: 1) Relative real interest rates are a major consideration for investors in foreign bonds and short term money market instruments. 2) Prospects for economic growth and profitability are an important determinant of cross-border equity investment in both securities and foreign direct investment. 3) Capital market liquidity is particularly important to foreign institutional investors. Cross-border investors are not only interested in the ease of buying assets, but also in the ease of selling those assets quickly for fair market value if desired. 4) A countrys economic and social infrastructure is an important indicator of that countrys ability to survive unexpected external shocks and to prosper in a rapidly changing world economic environment. 5) Political safety is exceptionally important to both foreign portfolio and direct investors. The outlook for political safety is usually reflected in political risk premiums for a countrys securities and for purposes of evaluating foreign direct investment in that country. 6) The credibility of corporate governance practices is important to cross-border portfolio investors. A firms poor corporate governance practices can reduce foreign investors influence and cause subsequent loss of the firms focus on shareholder wealth objectives. 7) Contagion is defined as the spread of a crisis in one country to its neighboring countries and other countries that have similar characteristics -- at least in the eyes of cross-border investors. Contagion can cause an innocent country to experience capital flight with a resulting depreciation of its currency. 8) Speculation can both cause a foreign exchange crisis or make an existing crisis worse. We will observe this effect through the three illustrative cases that follow shortly 2. Purchasing Power Parity In accordance with the PPP concept, the inflation differentials between countries affect the exchange rate, and consequently the PPP could be of good value in order to forecast the exchange rate. In Cochran & Defina study (Cochran & Defina 1995), they show that

the exchange rates, although they deviate from the PPP, they finally return to their PPP levels. However, during their deviation the possibility of the exchange rates moving backward from or forwards to the PPP remains the same, and consequently the PPP did not prove itself to be a consistent or reliable tool for forecasting. 3. Econometric Models The econometric models in their attempt to forecast the exchange rates take into consideration other factors that are regarded as determinants of the exchange rates. More specifically: inflation, the relative 19 GDP levels, the relative interest rates, and the relative money supply. Although the econometric models perform well in general, we can argue that these models do not lead to reliable forecasts because they use in many cases past data. In addition, it can be argued that empirical studies indicate that the ability of such models to forecast is greater in the long term than in the short term. 4. Technical Analysis Forecasting In contrast to the fundamental analysis that considers financial data, the technical analysis analyses diagrams based on past data. More specifically, it accepts the following: The market is efficient (all information is incorporated into the prices). The prices are moved by trend. The history repeats itself. The technical analysis takes into consideration indicators, such as moving averages and oscillators, the volume of transactions, trend lines, and time or price filters, and it combines their trend according to some charting rules. 20Then in turn the technical analysis tries to identify the future price and anticipate the price patterns in the financial and commodity markets. The applied chartist techniques, either on bar charts or on candlestick21 charts, lead to more reliable forecasts when dealing with short-term periods. 5. Forecasting services. Many treasurers subscribe to rather expensive on-line foreign exchange forecasting services even if these services have a dubious record of consistently correct forecasts. What might motivate a treasurer to continue to use a forecasting service? A treasurer might continue to use a forecasting service because it exists. If the treasurer does not use it, and guesses wrong on an exchange rate, the treasurer could be criticized for not using available expert advice. 6. Cross-rate consistency in forecasting. International financial managers must often forecast their home currency exchange rates for the set of countries in which the firm operates, not only to decide whether to hedge or to make an investment, but also as an integral part of preparing multi-country operating budgets in the home countrys currency. These are the operating budgets against which the performance of foreign subsidiary managers will be judged. Checking the reasonableness of the cross rates implicit in individual forecasts acts as a reality check to the original forecasts. CONCLUDING REMARKS In this assignment we initially analyzed the theories of exchange rate determination, and

we concluded that the exchange rate of a currency, just like commodities, determine its price responding to the forces of supply and demand. However, it remains difficult to evaluate the weight of each factor that influences the supply and demand flows. In this respect, we can argue that in the long term fundamental forces drive the currencys movements, e.g., inflation rates, interest rates, and GDP levels, to mention just a few, while in the short run, news and events drive the exchange rates movements. Moreover, we still remain unsure as to the ranking of the factors that finally determine the exchange rates. We have further considered various concepts and models thought to be reliable forecasters of the exchange rates. We have concluded that the forward rates are not good predictors of the future spot rates. In other words, the forward rate does not provide an unbiased estimate of the exchange rate movements. Taking into consideration the time horizons, we come to the conclusion that fundamental economic forces, such as purchasing power parity and the balance of payments, did not automatically affect the exchange rates, but they require a considerable amount of time. As a result they are not reliable over short time periods. Conversely, we can argue that the technical analysis performs comparatively well in the short run since news and events are incorporated into the diagrams and trends. We finally conclude the following: Firstly, the foreign exchange market is not an efficient one. Otherwise, it would be futile to beat or try to forecast the market. Secondly, because of so many determinants of the exchange rates, it is difficult to proceed to a reliable estimation for future rates. Thirdly, there is no unfailing method available to forecast exchange rates, and we have further determined that the forward
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When people decide to hedge, they are insuring themselves against a negative event.Investopdia.com

rate provides a biased estimate of the future spot rate. As a result, companies trading internationally face exposure to exchange rate risk. In this respect, the mentioned costly hedging22 instruments in Appendix 1 have been developed in order to manage the exposure related to unfavorable currency movements. More specifically, it can be argued that there is no perfect hedge or in other words a hedge with 100 % efficiency. What in practice happens is that a small profit or loss is made. For example, when an importing company has a liability that is payable in six months, it can hedge its exposure to exchange rate risk by using a forward contract. e.g., the company can buy the due amount at the six months forward rate. The company having used the aforementioned hedging instrument has no uncertainty about the exchange rate movements because it will pay a specific and previously known amount in its own currency. In other words, the company has locked its exposure, and consequently, its cost irrespective of whether or not the after six months spot rate proved to be in favour of or not in favour of his decision to hedge. Finally, we wish to underline that as indicated earlier, there are no unfailing methods to forecast exchange rates; consequently, the companies face an exposure related to the currencies fluctuation. However, their exposure to exchange rates movements can be managed, controlled, and even more, eliminated by using hedging instruments.