Chapter 10: Exchange Rate
Determination and Forecasting
Power Points created by:
Joseph F. Greco Ph. D.
California State University, Fullerton
Mihaylo College of Business and Economics
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Chapter 10: Exchange Rate
Determination and Forecasting
10.1
Parity Conditions and Exchange Rate
Forecasts
10.2
Currency Forecasting Techniques
10.3
Fundamental Exchange Rate Forecasting
10.4
Technical Analysis
10.5
Predicting Devaluations
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10.1 Parity Conditions and Exchange Rate
Forecasts
Parity Conditions and Exchange Rate
Forecasts: Overview
• The Fisher Hypothesis
• The International Parity Conditions
• Real Interest Rates and the Parity Conditions
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10.1 Parity Conditions and Exchange Rate
Forecasts
• The Fisher Hypothesis
• Interest rates and inflation
• Real rates of return
• The Ex Ante real interest rate
• Expected real interest rate
• Expected rate of inflation
• Fisher hypothesis
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Exhibit 10.1
Long-Term Government Bond Yields and Inflation
Rates (for Nine Countries, 1990-2000)
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10.1 Parity Conditions and Exchange Rate
Forecasts
• The International Parity Conditions
• CIRP
• UIRP or Unbiasedness
• PPP
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Exhibit 10.2
An Example of
International
Parity
Conditions: The
United Kingdom
and Switzerland
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10.1 Parity Conditions and Exchange Rate
Forecasts
• Real Interest Rates and the Parity Conditions
• Real interest rate parity
• Testing real interest rate parity
• Assessment
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Exhibit 10.3
Real Interest Rates at Different Maturities
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10.2 Currency Forecasting Techniques
Currency Forecasting Techniques: Overview
• Fundamental Exchange Rate Forecasting
• Exchange Rate Forecasting with Technical Analysis
• Evaluating Forecasts
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10.2 Currency Forecasting Techniques
• Fundamental Exchange Rate Forecasting
• Fundamental analysis
• Technique based on formal economic models
of exchange rate determination
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Exhibit 10.4
Categories of Exchange Rate Forecasting
Techniques
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10.2 Currency Forecasting Techniques
• Exchange Rate Forecasting with Technical Analysis
• Technical analysis
• Why technical analysis might work
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10.2 Currency Forecasting Techniques
• Evaluating Forecasts
• Accuracy
• Mean absolute error (MAE)
• Root mean squared error (RMSE)
• Being on the right side of the forward rate
• Percentage correct
• Profitability
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10.3 Fundamental Exchange Rate
Forecasting
Fundamental Exchange Rate Forecasting:
Overview
• The Asset market Approach to Exchange Rate Determination
• Sticky Prices and Overshooting
• The Real Exchange Rate and the Real Interest Rate Differential
• The Real Exchange Rate and the Current Account
• The Capital Account and Real Exchange Rates
• Equilibrium
• Variables That Affect the Real Exchange Rate-Current Account
Equilibrium
• Forecasting Performance of Fundamental Exchange Rate
Models
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10.3 Fundamental Exchange Rate
Forecasting
• The Asset market Approach to Exchange Rate
Determination
• The exchange rate as an asset price
• The monetary approach
• Real money balances
• Sticky Prices and Overshooting
• Responses to an increase in the money supply
• The link with UIRP
• The path of prices
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Exhibit 10.5
Responses
of Variables
to an
Increase in
the Money
Supply
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10.3 Fundamental Exchange Rate
Forecasting
• The Real Exchange Rate and the Real Interest Rate
Differential
• Converting UIRP to real terms
• Implications of an autoregressive process for the
real exchange rate
• Autoregressive process
• Empirical evidence
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Exhibit 10.6
Movements in the Real Dollar Exchange Rate
Relative to the Real Interest Rate Differential
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10.3 Fundamental Exchange Rate
Forecasting
• The Real Exchange Rate and the Current Account
• The trade balance and real exchange rates
• The Capital Account and Real Exchange Rates
• Equilibrium
• Variables That Affect the Real Exchange RateCurrent Account Equilibrium
• Net foreign assets
• Government spending and budget deficits
• Technological change and productivity growth
• Portfolio shifters
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Exhibit 10.7
Equilibrium Determination of the Current
Account and the Exchange Rate
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10.3 Fundamental Exchange Rate
Forecasting
• Forecasting Performance of Fundamental Exchange
Rate Models
• Forecasting models and benchmarks
• Empirical results
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10.4 Technical Analysis
Technical Analysis: Overview
• “Pure” Technical Analysis: Chartism
• Filter Rules
• Regression Analysis
• Evaluating Forecasting Services
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10.4 Technical Analysis
• “Pure” Technical Analysis: Chartism
• Support level
• Resistance level
• Breakout
• Potentially Spurious Patterns
• Trading on a Random Walk
• Does charting work?
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Exhibit 10.8
Exchange Rate Patterns Described by Chartists
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Exhibit 10.8
Exchange Rate Patterns Described by Chartists
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10.4 Technical Analysis
• Filter Rules
• x% rules
• Moving-average crossover rules
• Filter rule profitability
• Assessment
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10.4 Technical Analysis
• Regression Analysis
• Trading based on regressions
• Regression-based currency strategies in practice
• Evaluating Forecasting Services
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Exhibit 10.9
How Filter
Rules Work
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10.5 Predicting Devaluations
Predicting Devaluations: Overview
• What Causes a Currency Crisis?
• Empirical Evidence on the Predictability of Currency
Crisis
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10.5 Predicting Devaluations
• What Causes a Currency Crisis?
• Macroeconomic Conditions
• Self-fulfilling expectations
• Contagion
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10.5 Predicting Devaluations
• Empirical Evidence on the Predictability of Currency
Crisis
• 1991-1992: Currency turmoil in Europe
• 1994-1995: Mexican crisis and the Tequila effect
• 1997: The Southeast Asian crisis
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Exhibit 10.10 - Asian Exchange Rates
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