MultinationalBusinessFinanceSixteenthEditionChapter9ForeignExchangeRateDeterminationandInterventionCopyright?2022,2019and2016PearsonEducation,Inc.AllRightsReservedLearningObjectives9.1 Explorethethreemajortheoreticalapproachestoexchangeratedetermination9.2 Detailhowandwhydirectandindirectforeignexchangemarketinterventionisconductedbycentralbanks9.3 Analyzetheprimarycausesofexchangeratedisequilibriuminemergingmarketcurrencies9.4 ObservehowforecasterscombinetechnicalanalysiswiththethreemajortheoreticalapproachestoforecastingexchangeratesExchangeRateDetermination(1of2)Exchangeratedeterminationiscomplex.Exhibit9.1providesanoverviewofthemanydeterminantsofexchangerates.Thisroadmapisfirstorganizedbythethreemajorschoolsofthought(parityconditionsapproach,balanceofpaymentsapproach,monetaryandassetmarketapproaches),andsecondlybytheindividualdriverswithinthoseapproaches.Thesearenotcompetingtheoriesbutrathercomplementarytheories.Exhibit9.1TheDeterminantsofForeignExchangeRatesForlongdescription,seeslide41:Appendix1ExchangeRateDetermination(2of2)Twootherinstitutionaldimensionsareconsidered—whetherthecountrypossessesthecapitalmarketsandbankingsystemsneededtodriveanddiscovervalue.Mostdeterminantsofthespotexchangeratearemutuallydeterminedbychangesinthespotrate.ParityConditionsApproachThetheoryofpurchasing

power

parityisthemostwidelyacceptedtheoryofallexchangeratedeterminationtheories:PPPistheoldestandmostwidelyfollowedoftheexchangeratetheories.MostexchangeratedeterminationtheorieshavePPPelementsembeddedwithintheirframeworks.PPPcalculationsandforecastsare,however,plaguedwithstructuraldifferencesacrosscountriesandsignificantdatachallengesinestimation.BalanceofPaymentsApproachThebalance

of

payments

approachisthesecondmostutilizedtheoreticalapproachinexchangeratedetermination:Thebasicapproacharguesthattheequilibriumexchangerateisfoundwhencurrencyflowsmatchupvis-à-viscurrentandfinancialaccountactivities.ThisframeworkhaswideappealasBOPtransactiondataisreadilyavailableandwidelyreported.Criticsmayarguethatthistheorydoesnottakeintoaccountstocksofmoneyorfinancialassets.MonetaryApproachandAssetMarketApproach(1of5)Themonetaryapproachinitssimplestformstatesthattheexchangerateisdeterminedbythesupplyanddemandfornationalmonetarystocks,aswellastheexpectedfuturelevelsandratesofgrowthofmonetarystocks.Otherfinancialassets,suchasbonds,arenotconsideredrelevantforexchangeratedetermination,asbothdomesticandforeignbondsareviewedasperfectsubstitutes.MonetaryApproachandAssetMarketApproach(2of5)Theassetmarketapproacharguesthatexchangeratesaredeterminedbythesupplyanddemandforawidevarietyoffinancialassets:Shiftsinthesupplyanddemandforfinancialassetsalterexchangerates.Changesinmonetaryandfiscalpolicyalterexpectedreturnsandperceivedrelativerisksoffinancialassets,whichinturnalterexchangerates.MonetaryApproachandAssetMarketApproach(3of5)Theforecastinginadequaciesoffundamentaltheorieshasledtothegrowthandpopularityoftechnicalanalysis,thebeliefthatthestudyofpastpricebehaviorprovidesinsightsintofuturepricemovements.Theprimaryassumptionisthatanymarketdrivenprice(i.e.,exchangerates)followstrends.MonetaryApproachandAssetMarketApproach(4of5)Foreigninvestorsarewillingtoholdsecuritiesandundertakeforeigndirectinvestmentinhighlydevelopedcountriesbasedprimarilyonrelativerealinterestratesandtheoutlookforeconomicgrowthandprofitability.MonetaryApproachandAssetMarketApproach(5of5)Theasset

market

approachassumesthatwhetherforeignersarewillingtoholdclaimsinmonetaryformdependsonanextensivesetofinvestmentconsiderationsordrivers(amongothers):RelativerealinterestratesProspectsforeconomicgrowthCapitalmarketliquidityAcountry’seconomicandsocialinfrastructurePoliticalinstabilityCorporategovernancelawsandpracticesContagion(spreadofacrisiswithinaregion)SpeculationCurrencyMarketInterventionForeigncurrencyinterventionistheactivemanagement,manipulation,orinterventioninthemarket’svaluationofacountry’scurrency.WhyIntervene?Fightinflation(strongcurrency)Fightsloweconomicgrowth(weakcurrency)InterventionMethods(1of3)Methodsofinterventionaredeterminedbymagnitudeofacountry’seconomy,magnitudeoftradinginitscurrency,andthecountry’sfinancialmarketdevelopment.DirectInterventionTheactivebuyingandsellingofthedomesticcurrencyagainstforeigncurrencies.Ifthegoalistoincreasethevalue,thenthecentralbankbuysitsowncurrency.Ifthegoalistodecreasethevalue,thenthecentralbanksellsitsowncurrency.InterventionMethods(2of3)Ifbankinterventionisinsufficient,thencoordinatedinterventionmaybeusedwherebyseveralcentralbanksagreeonastrategytoincreaseordecreaseacurrencyvalue.IndirectInterventionThealterationofeconomicorfinancialfundamentalswhicharethoughttobedriversofcapitaltoflowinandoutofspecificcurrencies.Increaserealratestostrengthenacurrency.Decreaserealratestoweakenacurrency.InterventionMethods(3of3)Capitalcontrolsarerestrictionsofaccesstoforeigncurrencybythegovernmentbylimitingtheexchangeofdomesticcurrencyforforeigncurrency.Althoughinterventionmayfail,understandingthemotivationsandmethodsforcurrencymarketinterventioniscriticaltoanyanalysisofthedeterminationoffutureexchangerates.WhenForeignCurrencyInterventionFailsItisimportanttorememberthatinterventionmay—andoftendoes—fail.Turkishcurrencycrisisof2014isaclassicexampleofadrasticindirectinterventionthatultimatelyonlyslowedtherateofcapitalflightandcurrencycollapse.TheBankofJapanintervenedintheforeignexchangemarketsin2010inanattempttoslowtheappreciatingyenbybuyingU.S.dollars.AsillustratedinExhibit9.2,theinterventionwaslargelyunsuccessful.Exhibit9.3illustrateswhatJapanwasattemptingtodothroughitsintervention.Exhibit9.2InterventionandtheJapaneseYen,2010Forlongdescription,seeslide42:Appendix2Exhibit9.3InterventionandtheJapaneseYen:DrivingtheYenDown)Forlongdescription,seeslide43:Appendix3InterventionbytheBankofJapaninvolvestheBankenteringtheforeignexchangemarkettodemanddollars—tobuyU.S.dollarsinexchangeforJapaneseyen.IftheBank’stimingandmagnitudeofinterventionaresufficient,itcanshiftthedemandforU.S.dollarsoutward,drivingthepriceofthedollarupandthevalueoftheyendown(nowtakingmoreyentopurchaseonedollar).Disequilibrium:ExchangeRatesinEmergingMarketsAlthoughthethreedifferentschoolsofthoughtonexchangeratedeterminationmakeunderstandingexchangeratesappeartobestraightforward,thatitrarelythecase.Thelargeandliquidcapitalandcurrencymarketsfollowmanyoftheprinciplesoutlinedsofarrelativelywellinthemediumtolongterm,butthesmallerandlessliquidmarketsfrequentlydemonstratebehaviorsthatseeminglycontradictthetheory.Theproblemliesnotinthetheory,butintherelevanceoftheassumptionsunderlyingthetheory.TheAsianCrisisof1997(1of3)TherootsoftheAsiancurrencycrisisextendedfromafundamentalchangeintheeconomicsoftheregion,thetransitionofmanyAsiannationsfrombeingnetexporterstonetimporters.ThemostvisiblerootsofthecrisisweretheexcesscapitalinflowsintoThailandin1996andearly1997.Astheinvestment“bubble”expanded,somemarketparticipantsquestionedtheabilityoftheeconomytorepaytherisingamountofdebtandtheThaibhatcameunderattack.TheAsianCrisisof1997(2of3)TheThaigovernmentinterveneddirectly(usingupprecioushardcurrencyreserves)andindirectlybyraisinginterestratesinsupportofthecurrency.Soonthereafter,theThaiinvestmentmarketsgroundtoahaltandtheThaicentralbankallowedthebhattofloat.Thebhatfelldramatically(seeExhibit9.4)andsoonotherAsiancurrencies(Philippinepeso,Malaysianringgit,andtheIndonesianrupiah)cameunderspeculativeattack.Exhibit9.4TheThaiBahtandtheAsianCrisisForlongdescription,seeslide44:Appendix4TheAsianCrisisof1997(3of3)TheAsianeconomiccrisis(whichwasmuchmorethanjustacurrencycollapse)hadmanyrootsbesidestraditionalbalanceofpaymentsdifficulties:CorporatesocialismCorporategovernancecronyismBankinginstabilityWhatstartedasacurrencycrisisbecamearegion-widerecession.OthercountriesblamedtheinternationalfinancierGeorgeSorosforcausingthecrisiswithhispoliticalagenda.TheArgentineCrisisof2002(1of3)In1991,theArgentinepesohadbeenfixedtotheU.S.dollarataone-to-onerateofexchange.Acurrency

board

structurewasimplementedinanefforttoeliminatethesourceinflationthathaddevastatedthenation’sstandardoflivinginthepast.TheArgentineCrisisof2002(2of3)By2001,afterthreeyearsofrecession,threeimportantproblemswiththeArgentineeconomybecameapparent:TheArgentinepesowasovervalued.Thecurrencyboardregimehadeliminatedmonetarypolicyalternativesformacroeconomicpolicy.TheArgentinegovernmentbudgetdeficit—anddeficitspending—wasoutofcontrol.TheArgentineCrisisof2002(3of3)InJanuary2002,thepesowasdevaluedasaresultofenormoussocialpressuresresultingfromdeterioratingeconomicconditionsandsubstantialrunsonbanks.However,theeconomicpaincontinuedandthebankingsystemremainedinsolvent.Socialunrestcontinuedastheeconomicandpoliticalsystemswithinthecountrycollapsed;certaingovernmentactionssetthestageforaconstitutionalcrisis.Exhibit9.5tracksthedeclineoftheArgentinepeso.Exhibit9.5TheCollapseoftheArgentinePesoForlongdescription,seeslide45:Appendix5CurrencyForecastinginPracticeExhibit9.6summarizesthevariousforecastingperiods,regimes,andmostwidelyfollowedmethodologies.Whetheranyoftheforecastingservicesareworththeircostdependsbothonthemotiveforforecastingaswellastherequiredaccuracy.Thelongerthetimehorizonoftheforecast,themoreinaccurate,butalsothelesscriticaltheforecastislikelytobe.Accuracyofshort-termforecastsiscritical,sincemostoftheexchangeratechangesarerelativelysmalleventhoughtheday-to-dayvolatilitymaybehigh.Exhibit9.6ExchangeRateForecastinginPracticeForecastPerioRegimeRecommendedForecastMethodsShortRunFixed-RateFloating-RateAssumethefixed-rateismaintainedArethereindicationsofstressonthefixed-rate?Aretherecapitalcontrolsorblackmarketexchanges?4Arethereindicatorsofgovernment’scapabilitytomaintainthefixed-rate?Aretherechangesinforeigncurrencyreserves?TechnicalmethodswhichcapturetrendForwardratesasforecasts(<30daysassumerandomwalk;30-90daysuseforward)Forperiodsof90-360dayscombinetrendwithfundamentalanalysisFundamentalanalysisofinflationaryconcernsGovernmentdeclarationsandagreementsregardingexchangerategoalsCooperativeagreementswithothercountriesLongRunFixed-RateFloating-RateFundamentalanalysisBalanceofpaymentsmanagementAbilitytocontroldomesticinflationAbilitytogeneratehardcurrencyreservestouseforinterventionpurposesAbilitytoruntradeaccountsurplusesFocusoninflationaryfundamentalsandpurchasingpowerparityIndicatorsofgeneraleconomichealthsuchaseconomicgrowthandstabilityTechnicalanalysisoflong-termtrends(possibilityoflong-termtechnical‘waves’)GovernmentpositionsonrelativeinternationalcompetitivenessandboundariesTechnicalAnalysis(1of2)Technical

analysts,traditionallyreferredtoaschartists,focusonpriceandvolumedatatodeterminepasttrendsthatareexpectedtocontinueintothefuture.Thesinglemostimportantelementoftechnicalanalysisisthatfutureexchangeratesarebasedonthecurrentexchangerate.Exchangeratemovementscanbesubdividedintothreeperiods:Day-to-dayShort-term(severaldaystoseveralmonths)Long-termTechnicalAnalysis(2of2)Manyoftheforecastneedsofthefirmareshorttomediumtermintheirtimehorizonandcanbeaddressedwithlesstheoreticalapproaches.Thesetechnicalanalysesbasedontime—timeseriestechniques—infernotheoryorcausalitybutsimplypredictfuturevaluesfromtherecentpast.Forecastersfreelymixfundamentaltheoriesandtechnicalanalysisbecauseforecastingisaboutjustgettingclose.Exhibit9.7illustrateshowaccurateoneprestigiousforecasterwasoverathree-yearperiod.Exhibit9.7JPMorganChaseForecastoftheU.S.Dollar-EuroForlongdescription,seeslide46:Appendix6Cross-RateConsistencyinForecastingInternationalfinancialmanagersforecasttheirhomecurrencyexchangeratesforavarietyofreasonsincluding:DecidewhethertohedgeDecidewhethertomakeinvestmentsTopreparemulti-countryoperatingbudgetsinthehomecountry’scurrencyCheckingcross-rateconsistencyassessesthereasonablenessofthecross-rateimplicitinindividualforecasts.Forecasting:WhattoThink?(1of2)Itappears,fromdecadesoftheoreticalandempiricalstudies,thatexchangeratesdoadheretothefundamentalprinciplesandtheoriespreviouslyoutlined.FundamentalsdoapplyinthelongtermThereis,therefore,somethingofafundamental

equilibrium

pathforacurrency’svalue.Forecasting:WhattoThink?(2of2)Italsoseemsthatintheshortterm,avarietyofrandomevents,institutionalfrictions,andtechnicalfactorsmaycausecurrencyvaluestodeviatesignificantlyfromtheirlong-termfundamentalpath.Thisbehaviorissometimesreferredtoasnoise.Therefore,wemightexpectdeviationsfromthelong-termpathnotonlytooccur,buttooccurwithsomeregularityandrelativelongevity.Exhibit9.8illustratesthesynthesisofforecastingthought.Exhibit9.8Short-TermNoiseVersusLong-TermTrendsForlongdescription,seeslide47:Appendix7Ifmarketparticipantshavestabilizingexpectations,whenforcesdrivethecurrency’svaluebelowthelong-termfundamentalequilibriumpath,theywillbuythecurrencydrivingitsvaluebacktowardthefundamentalequilibriumpath.Ifmarketparticipantshavedestabilizingexpectations,andforcesdrivethecurrency’svalueawayfromthefundamentalpath,participantsmaynotmoveimmediatelyorinsignificantvolumetopushthecurrency’svaluebacktowardthefundamentalequilibriumpathforanextendedperiodoftime(orpossiblyestablishanewlong-termfundamentalpath).ExchangeRateDynamics:MakingSenseofMarketMovementsAlthoughthevarioustheoriessurroundingexchangeratedeterminationareclearandsound,itmayappearonaday-to-daybasisthatthecurrencymarketsdonotpaymuchattentiontothetheories.Currencymarketsaresubjecttonewnewseveryhourofeveryday,makingitverydifficulttoforecastexchangeratemovementsinshortperiodsoftime.Inthelongerterm,asshowninExhibit9.9,themarketsdocustomarilyreturntothefundamentalsofexchangeratedetermination.Exhibit9.9ExchangeRateDynamics:OvershootingForlongdescription,seeslide48:Appendix8CopyrightThisworkisprotectedbyUnitedStatescopyrightlawsandisprovidedsolelyfortheuseofinstructorsinteachingtheircoursesandassessingstudentlearning.Disseminationorsaleofanypartofthiswork(includingontheWorldWideWeb)willdestroytheintegrityoftheworkandisnotpermitted.Theworkandmaterialsfromitshouldneverbemadeavailabletostudentsexceptbyinstructorsusingtheaccompanyingtextintheirclasses.Allrecipientsofthisworkareexpectedtoabidebytheserestrictionsandtohonortheintendedpedagogicalpurposesandtheneedsofotherinstructorswhorelyonthesematerials.Appendix1LongDescriptionforExhibit9.1Theflowchartillustratesthreeapproachestodeterminingtheexchangerate.Thethreemajorschoolsofthoughtonthedeterminationofthespotexchangerateincludetheparityconditionsapproach,thebalanceofpaymentsapproach,andthemonetaryapproachandassetmarketapproach.Thefollowinglistprovidesthecomponentsofeachapproach:Parityconditionsapproach.LawofOnePrice,AbsolutePurchasingPowerParity,RelativePurchasingPowerParity,InterestRateParity.Balanceofpaymentsapproach,whichincludes.Currentaccountbalances,Portfolioinvestment,Foreigndirectinvestment,Exchangerateregimes,Officialmonetaryreserves.Monetaryapproachandassetmarketapproach.Themonetaryapproachsfocusesonsupplyanddemandfornationalmonetarystocks,only.Theassetmarketapproachfocusesonsupplyanddemandforfinancialassetsofawidevarietyincludingbonds.Forfinancialmarkets,exchangeratedeterminationdependsonthefollowingquestion.Isthereawell-developedandliquidmoneyandcapitalmarketinthatcurrency?Forthebankingsystem,exchangeratedeterminationdependsonthefollowingquestion.Isthereasoundandsecurebankingsysteminplacetosupportcurrencytrading?ReturntopresentationAppendix2LongDescriptionforExhibit9.2Thegraphoftheyentodollarexchangeraterisesandfalls.Alineextendsthrougheachconsecutivepairofsubperiodhighpointsandlowpoints,sothateachlineapproximatestheriseorfalloftheactualgraph.Thefollowinglistdetailsthetrendsrepresentedbythegraph.Theraterosefromnear92to93inJanuary2010,fluctuatingtillMarch2010,reachingapeakof94.71YeninApril2010.ThelinehasadownwardtrendfromJune2010tillSeptember2010whentheBankofJapaninterventionSeptember13asyenhits15-yearhigh.Thecurvereaches80.67yenagainstdollarinNovember2010,fluctuatingandtrailingdownto80inDecember2010.ReturntopresentationAppendix3LongDescriptionforExhibit9.3Thegraphofthedollartoyenpriceratioversusdailydollartoyentradingincludessupplyanddemandcurves.ThecurveforthesupplyofUSdollarsversustheJapaneseyentothemarketrisesfromlefttoright.TheDemand1curvefallsdiagonallythroughpointPsub1onthesupplycurveat(Vsub1,JPY80equalsUSD1.00).InterventionshiftstheDemand1curveupwardandrightwardtoformtheDemand2curve.TheDemand2curveintersectspointPsub2onthesupplycurveat(Vsub2,JPY100equalsUSD1.00).ReturntopresentationAppendix4LongDescriptionforExhibit9.4ThegraphofthebahttoUSDexchangeratedemonstratesthetrendsdescribedinthefollowinglist.Allvaluesareestimated.Therateremainednear26fromApriltomidMay.ThegovernmentintervenedheavilyinMayandJunetothwartrumorsofthebaht’spotentialfall.Theratedeclinedtonear22bymidJune.OnJuly2,theThaibahtofficiallyfloated,fallingfromTHB25toTHB29equalsUSD1inhours.AsmoreAsiancurrenciesfellinJulyandAugust,thebahtcontinuedtofallundermarketpressure.Inturn,theraterosefrom29atthebeginningofJulytoaperiodhighofover26inthesecondhalfofSeptember.TheAsiancrisisandthefalloftheThaibahtdemonstratehowmyopictheinternationalmarketcanbecome,havingignoredseriouscurrentaccountdeficitsinThailandforyears.ReturntopresentationAppendix5LongDescriptionforExhibit9.5Thegraphofthepesotodollarexchangeratedemonstratesthetrendsdescribedinthefollowinglist.Allvaluesareestimated.TherateremainedfixedbytheCurrencyBoardatARS1.00equalsUSD1.00fromNovember2001toJanuary2002.OnFebruary3,2002,thegovernmentofficiallyannouncedthefloatationofthepeso,andtheratespikedtonear2.2.Roughlysixmonthsbeforestabilization,theratecontinuedtoriseatagenerallydecreasingpace,approaching3.6attheendofJuly2002.Duringthisperiod,theratereachednotablehighsat3.7inMarch2002andat3.9inJune2002.Argentina’sCurrencyBoardwasanextremesystemdesignedtoeliminatetheabilityofgovernmenttoconductindependentmonetarypolicy.Itwastheresultofyearsofdisastrousinflationarysufferingfrompoorpolicy