CHAPTER 9
FOREIGN EXCHANGE RATE
DETERMINATION AND INTERVENTION
1. Exchange Rate Determination. What are the three basic theoretical approaches to
exchange rate determination?
The three major schools of thought are 1) purchasing power parity, 2) balance of
payments approach, and 3) asset market approach.
Purchasing Power Parity Approach. The most widely accepted 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
Balance of Payments Approach. After PPP, the most frequently used theoretical
approach to exchange rate determination is probably that involving the supply and
demand for currencies in the foreign exchange market. These exchange rate flows
reflect current account and financial account transactions recorded in a nation’s
2. PPP Inadequacy. The most widely accepted theory of foreign exchange rate
determination is purchasing power parity, yet it has proven to quit poor at forecasting
future spot exchange rates. Why?
Although PPP seems to possess a core element of common sense, it has proven to be
quite poor at forecasting exchange rates (at least in the short to medium-term). The
3. Data and the Balance of Payments Approach. Statistics on a country’s balance of
payments are used by the business press and business itself often in terms of
predicting exchange rates, but the academic profession is highly critical of it. Why?
4. Supply and Demand. Which of the three major theoretical approaches seems to put
the most weight into arguments on the supply and demand for currency? What is its
primary weakness?
The monetary approach focuses on changes in the supply and demand for money as
the primary determinant of inflation. Changes in relative inflation rates in turn are
expected to alter exchange rates through a purchasing power parity effect. The
monetary approach then assumes that prices are flexible in the short run as well as the
5. Asset Market Approach to Forecasting. Explain how the asset market approach can
be used to forecast future spot exchange rates. How does the asset market approach
differ from the BOP approach to forecasting?
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:
▪ 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 country’s securities and for purposes of evaluating foreign direct
investment in that country.
▪ The credibility of corporate governance practices is important to cross-border
portfolio investors. A firm’s poor corporate governance practices can reduce
foreign investors’ influence and cause subsequent loss of the firm’s focus on
shareholder wealth objectives.
6. Traders versus Investors. How do you distinguish between traders and investors?
Both financial traders and investors participate in the same financial markets.
However, they differ on a number of aspects as they follow two very different
strategies. First, when traders purchase shares, their focus is on the market rather than
the performance of the firm. Second, investors mostly rely on fundamental analysis
7. Financial Analysis. What is the difference between technical and fundamental
analysis?
While technical analysis uses the historical behaviour of price fluctuations of a
financial instrument to predict its future price movements, fundamental analysis
examines the fundamental financial and economic factors to analyze it. Since
technical traders believe that a company’s fundamentals are accounted for in the
8. Intervention Motivation. Why do governments and central banks intervene in the
foreign exchange markets? If markets are efficient, why not let them determine the
value of a currency?
Historically, a primary motive for a government to pursue currency value change was
to keep the country’s currency cheap so that foreign buyers would find its exports
cheap. This policy, long referred to as “beggar-thy-neighbor,” gave rise to many
competitive devaluations over the years. It has not, however, fallen out of fashion.
Alternatively, the fall in the value of the domestic currency will sharply reduce the
purchasing power of its people. If the economy is forced, for a variety of reasons, to
9. Direct Intervention Usefulness. When is direct intervention likely to be the most
successful? And when is it likely to be the least successful?
10. Capital inflow volatility. Can governments dampen capital inflow volatility in
emerging nations?
Capital inflows are desirable since they help correct capital account and balance of
trade deficits. Sometimes, however, capital inflows could be harmful. For example, in
many emerging market economies capital inflows may prove to be volatile, hence
increasing uncertainty and hampering investment decisions in these nations. Volatile
capital inflows in emerging market economies are usually in the form of foreign
11. Capital Controls. Are capital controls really a method of currency market
intervention, or more of a denial of activity? How does this fit with the concept of the
impossible trinity?
This is the restriction of access to foreign currency by government. This involves
limiting the ability to exchange domestic currency for foreign currency. When access
and exchange is permitted, trading takes place only with official designees of the
government or central bank, and only at dictated exchange rates.
12. Asian Crisis of 1997 & Disequilibrium. What was the primary disequilibrium at
work in Asia in 1997 which likely caused the Asian financial crisis? Do you think it
could have been avoided?
The roots of the Asian currency crisis extended from a fundamental change in the
economics of the region, the transition of many Asian nations from being net
exporters to net importers. Starting as early as 1990 in Thailand, the rapidly
13. Motivations for Currency Market Intervention. Why and when do central banks
intervene in currency markets?
Central banks intervene in foreign exchange markets for a number of reasons. The
traditional motivation is to devalue the domestic currency in order to make exports
less expensive and imports dearer, hence solving balance-of-payments problems.
14. Currency Crises. Compare and contrast the currency crises of Russia in 1998 and
Argentina in 2002.
After the dissolution of the USSR in 1991, the Russian economy went through major
restructuring. The escalating Russian foreign debt in US dollars (both private and
public) was mostly remitted abroad. Private individuals needed to acquire assets
abroad and governments were repaying the massive outstanding debt that was
inherited from previous regimes. As capital flew out of Russia, foreign MNEs
minimized cash holdings in their Russian subsidiaries. Furthermore, foreign currency
earnings from the exports fell with the slow global demand and the Asian crisis.
These deteriorating conditions in Russia made foreign debt and capital account
deficits unmanageable, leading to a major currency crisis in 1998.
15. Term Forecasting. What are the major differences between short-term and long-term
forecasts for a fixed exchange rate versus a floating exchange rate?
Long-run forecasts may be motivated by a multinational firm’s desire to initiate a
foreign investment in Japan, or perhaps to raise long-term funds denominated in
Short-term forecasts are typically motivated by a desire to hedge a receivable,
payable, or dividend for perhaps a period of three months. In this case the long-run
economic fundamentals may not be as important as technical factors in the
marketplace, government intervention, news, and passing whims of traders and
investors. Accuracy of the forecast is critical since most of the exchange rate changes
are relatively small even though the day-to-day volatility may be high.
16. Inflationary nations. Why are most export prices in inflationary nations quoted in
terms of stable currencies?
During high and uncertain inflation, both exporters and importers will face
uncertainty as to the real price of the goods being traded. Exporters face the risk of
earning lower revenue due to higher-priced products. Conversely, importers face the
risk that the real cost of products will increase. The persistence of inflationary
17. Speculation and Financial Crises. Excessive currency speculation has been named
among the factors blamed for the onset of financial crises. Give three examples where
rampant speculation has given birth to financial crises. What other factors are also
blamed for these crises?
Speculation is an activity that aims at gaining returns from the purchase of assets in
the expectation of profiting from its sale at a higher price. There is a wide range of
18. Cross-Rate Consistency in Forecasting. Explain the meaning of “cross-rate
consistency” as used by MNEs. How do MNEs use a check of cross-rate consistency
in practice?
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 country’s currency. These are the operating
19. Stabilizing Versus Destabilizing Expectations. Define stabilizing and destabilizing
expectations, and describe how they play a role in the long-term determination of
exchange rates.
If market participants have stabilizing expectations, when forces drive the currency’s
value below the long-term fundamental equilibrium path, they will buy the currency
20. Currency Forecasting Services. MNEs with multiple foreign subsidiaries depend on
currency forecasting to plan future expansion and contraction of their operations.
What are the criteria that analysts use to forecast future exchange rates?
Many multinational firms resort to foreign exchange forecasting to help them
estimate the exchange rate at future dates in order to help them decide on investment
plans as well as the currencies at which they should take up loans. Most analysts
acknowledge that there may be limitations to the accuracy of their forecasts. There