Foreign Exchange Rate Forecasting

Foreign Exchange Rate Forecasting If you KNOW FOR SURE what exchange rates will be… you could make millions of dollars IN ONE DAY… so this is all about FORECASTING what the exchange rate will be (to make money)

Background: Infrastructure weaknesses were among the major causes of the exchange rate collapses in emerging markets in the late 1990s. and also explain why the U.S. dollar continued to be strong, at least until the September 11,2001, despite record balance of payments deficits on current account.

Speculation contributed greatly to the emerging market crises. Characteristics of speculation are hot money flowing into and out of currencies, securities, real estate, and commodities. *Uncovered interest arbitrage caused by exceptionally low borrowing interest rates in Japan coupled with high real interest rates in the United States was a problem for much of the 1990s. *Borrowing yen to invest in safe U.S. government securities, hoping that the exchange rate did not change, was popular.

Cross-border foreign direct investment dried up during their crises.

Foreign political risks have been much reduced in recent years as capital markets became less segmented from each other and more liquid. More countries adopted democratic forms of government. Contagion is defined as the spread of a crisis in one country to its neighboring countries. Contagion can cause an “innocent” country to experience capital flight and a resulting depreciation of its currency. Speculation can cause a foreign exchange crisis or make an existing crisis worse THEORIES to forecast exchange rates… In order to make MONEY!!!! 1. Purchasing Power Parity Approaches The most widely accepted theory of all exchange rate determination theories, the theory of purchasing power parity (PPP), states that the long-run equilibrium exchange rate is determined by the ratio of domestic prices relative to foreign prices. PPP is both the oldest and most widely followed of the exchange rate theories. PPP calculations and forecasts, however, may be plagued with structural differences

2. Balance of Payments (Flows) Approaches The second most frequently used theoretical approach to exchange rate determination is probably the balance of payments approach. • The basic balance of payments approach argues that the equilibrium exchange rate is found when the net inflow (outflow) of foreign exchange arising from current account activities matches the net outflow (inflow) of foreign exchange arising from financial account activities. • Criticisms of the balance of payments approach arise from the theory’s emphasis on flows of currency and capital rather than stocks of money or financial assets. 3. Monetary Approaches (less popular, less important) The monetary approach states that the exchange rate is determined by the supply and demand for and growth of national monetary stocks. Changes in the supply and demand for money are the primary determinants of inflation. In monetary models of exchange rate determination, real economic activity is relegated to a role in which it influences only exchange rates through any alterations to the demand for money. The monetary approach omits a number of factors 1) the failure of PPP to hold in the short to medium term; 2) money demand appearing to be relatively unstable over time; and 3) the level of economic activity and the money supply appearing to be interdependent. 4. Asset Market Approach (Relative Price of Bonds) The asset market approach, argues that exchange rates are determined by the supply and demand for a wide variety of financial assets. • Shifts in the supply and demand for financial assets alter exchange rates. • Changes in monetary and fiscal policy alter expected returns and perceived relative risks of financial assets, which in turn alter exchange rates. Unfortunately, none of the fundamental theories have proven that useful in the short to medium term to predict exchange rates!

5. Technical Analysis USING CHARTS TO FIND TRENDS The belief that the study of past price behavior provides insights into future price movements. The primary feature of technical analysis is the assumption that exchange rates, follows trends. And those trends may be analyzed and projected.

6. The Asset Market Approach to Forecasting EXCHANGE RATES based on DEMAND of a currency by foreigners based on: • Relative real interest rates • Prospects for economic growth and profitability • A country’s economic and social infrastructure • Political safety • The credibility of corporate governance.

1990’s: The heavy inflow of foreign capital into the U.S. stock market and real estate, motivated by good long-run prospects for growth and profitability in the United States. This time the bubble burst following the September 11, 2001, terrorist attack on the United States. Loss of confidence in the U.S. … dollar depreciated. Asian Crisis: 1980’s Asian countries became EXPORTERS… growth opportunities went up. Investor money flowed in. THEN citizens got wealthy and countries became NET IMPORTERS. So investor money became more important to fund their growth. Citizen’s savings rate went down. Needed outside money to fund growth. Started borrowing too much money from outsiders.

1997: investors got worried of debt default… pulled money OUT of Thailand, then out of Indonesia, Philippines, Malaysia, Hong Kong, Korea. Currencies came under attack, money was made on puts and selling forward contracts as currencies dropped as investors pulled money OUT of those countries. Hong Kong, Japan, and China were not effected much due to their strength.

Tequilia Effect: 1994 drop in Mexican Peso soon spread to Latin American Countries. 1997: Drop in Thai Bhat spread to other Asian countries.

Argentina: had horrible inflation in 1980’s. Hurts economy. Solution: adopted a currency board – for each peso on streets… held 1 US dollar in reserves. It worked well to keep inflation down for a few years. Problem: couldn’t get enough MORE dollars in reserves in order to expand Peso money supply on streets. Economy slowed to a halt. 2001: Peso overvalued, monetary policy was eliminated, gov. budget deficits. 2001: unemployment, riots, bank runs, several Presidents came and went Result: devalued Peso (floated it)… Peso then fell dramatically. Argentina has since recovered somewhat.

Venezuela: 1998: Chavez elected with liberal promises. Adopts isolationist policy. Bolivar depreciates. People tried to dump Bolivars. Chavez made is more difficult to dump Bolivars and buy dollars. Businesses NEEDED dollars to buy medicines, etc. from overseas. Had trouble getting the dollars under Chavez. Chavaz set an exchange rate but blackmarket rate was different. CADVI was a government agency to help obtain dollars but had to be a supported to go through that route. Anti-Chavez petitioners were denied. LOOPHOLE: you could buy stock in CANTV with Bolivars… then later sell stock for dollars. All of this HURTS the economy of Venezuela. High oil prices help though bring in hard dollars to Venezuela.