Predicting Exchange Rates

Businesses need to hedge foreign exchange risk due to uncertainty over future exchange rates. This pages looks at the main determinants of exchange rates, whether or not they can be predicted and with what level of certainty.

Why exchange rates fluctuate

Changes in exchange rates result from changes in the demand for and supply of the currency. These changes may occur for a variety of reasons, e.g. due to changes in international trade or capital flows between economies.

Balance of payments

Since currencies are required to finance international trade,changes in trade may lead to changes in exchange rates.

In principle:

• demand for imports in the US represents a demand for foreign currency or a supply of dollars
• overseas demand for US exports represents a demand for dollars or a supply of the foreign currency.

Thus a country with a current account deficit where imports exceed exports may expect to see its exchange rate depreciate, since the supply of the currency (imports) will exceed the demand for the currency (exports).

Any factors which are likely to alter the state of the current account of the balance of payments may ultimately affect the exchange rate.

Capital movements between economies

There are also capital movements between economies. These transactions are effectively switching bank deposits from one currency to another. These flows are now more important than the volume of trade in goods and services.

Thus supply/demand for a currency may reflect events on the capital account.

Several factors may lead to inflows or outflows of capital:

• changes in interest rates: rising (falling) interest rates will attract a capital inflow (outflow) and a demand (supply) for the currency
• inflation: asset holders will not wish to hold financial assets in a currency whose value is falling because of inflation.

These forces which affect the demand and supply of currencies and hence exchange rates have been incorporated into a number of formal models.

Exchange rate systems

Although the world's leading trading currencies, like the US dollar, Japanese yen, British pound and European Euro are floating against the other currencies, a minority of countries use floating exchange rates.

The main exchange rate systems include:

Fixed exchange rates

This involves publishing the target parity against a single currency (or a basket of currencies), and a commitment to use monetary policy (interest rates) and official reserves of foreign exchange to hold the actual spot rate within some trading band around this target.

Fixed against a single currency

This is where a country fixes its exchange rate against the currency of another country's currency. More than 50 countries fix their rates in this way, mostly against the US dollar. Fixed rates are not permanently fixed and periodic revaluations and devaluations occur when the economic fundamentals of the country concerned strongly diverge (e.g. inflation rates).

Fixed against a basket of currencies

Using a basket of currencies is aimed at fixing the exchange rate against a more stable currency base than would occur with a single currency fix. The basket is often devised to reflect the major trading links of the country concerned.

Historical perspective: British pound previously used a fixed rate system

The pound was fixed against the US dollar from 1945 to 1972, and more recently was part of the European Exchange Rate Mechanism (ERM) between 1990 and 1992. The rules of the ERM were complicated, UK membership of the ERM involved a target rate of 2.95 DM against the £with a +/- 6% trading band: in other words, a minimum spot rate of around 2.77DM. To hold sterling above this rate in 1992, the government used a significant amount of the UK's foreign currency reserves and a high interest rate policy. Following its failure to defend the pound within the system, the UK left the ERM in September 1992.

Freely floating exchange rates (sometimes called a clean float)

A genuine free float would involve leaving exchange rates entirely to the vagaries of supply and demand on the foreign exchange markets,and neither intervening on the market using official reserves of foreign exchange nor taking exchange rates into account when making interest rate decisions. The Monetary Policy Committee of the Bank of England clearly takes account of the external value of sterling in its decision-making process, so that although the pound is no longer in a fixed exchange rate system, it would not be correct to argue that it is on a genuinely free float.

Managed floating exchange rates (sometimes called a dirty float)

The central bank of countries using a managed float will attempt to keep currency relationships within a predetermined range of values (not usually publicly announced), and will often intervene in the foreign exchange markets by buying or selling their currency to remain within the range.

Predicting exchange rate movements

Purchasing Power Parity Theory (PPPT)

PPPT claims that the rate of exchange between two currencies depends on the relative inflation rates within the respective countries. PPPT is based on 'the law of one price', which states that in equilibrium, identical goods must cost the same, regardless of the currency in which they are sold.

PPPT predicts that the country with the higher inflation will be subject to a depreciation of its currency.

 If you need to estimate the expected future spot rates, simply apply the following formula:

Where:

• S₀ = Current spot
• S₁ = Expected future spot
• h_b = Inflation rate in country for which the spot is quoted (base currency)
• h_c = Inflation rate in the other country. (counter currency)

PPPT can be used as our best predictor of future spot rates; however it suffers from the following major limitations:

• the future inflation rates are only estimates
• the market is dominated by speculative transactions (98%) as opposed to trade transactions; therefore purchasing power theory breaks down
• government intervention: governments may manage exchange rates, thus defying the forces pressing towards PPPT.

It is likely that the purchasing power parity model may be more useful for predicting long-run changes in exchange rates since these are more likely to be determined by the underlying competitiveness of economies, as measured by the model

Interest Rate Parity Theory (IRPT)

The IRPT claims that the difference between the spot and the forward exchange rates is equal to the differential between interest rates available in the two currencies. (Note: The forward rate is a future exchange rate, agreed now, for buying or selling an amount of currency on an agreed future date.)

IRPT predicts that the country with the higher interest rate will see the forward rate for its currency subject to a depreciation.

If you need to calculate the forward rate in one year's time:

Where:

• F₀ = Forward rate
• i_b = interest rate for base currency
• i_c = interest rate for counter currency

You are provided with this formula in the exam.

The IRPT generally holds true in practice. There are no bargain interest rates to be had on loans/deposits in one currency rather than another.

However it suffers from the following limitations:

• government controls on capital markets
• controls on currency trading
• intervention in foreign exchange markets.

The Fisher Effect

The Fisher Effect looks at the relationship between interest rates and expected rates of inflation. It is expressed by the formula:

(1 + i) = (1 + r)(1 + h)

Where

• i = the money rate of interest
•  r = the real rate of interest and
• h = general level of inflation in the economy

This states that the money or nominal rate of interest is made up of two parts, the underlying required rate of return (real interest rate) and a premium to allow for inflation.

Countries with high rates of inflation will be expected to have nominal rates of interest in order to ensure investors can obtain a high enough real return.

The International Fisher Effect

The International Fisher Effect claims that the interest rate differentials between two countries provide an unbiased predictor of future changes in the spot rate of exchange.

• The International Fisher Effect assumes that all countries will have the same real interest rate, although nominal or money rates may differ due to expected inflation rates.
• Thus the interest rate differential between two countries should be equal to the expected inflation differential.
• Therefore, countries with higher expected inflation rates will have higher nominal interest rates, and vice versa.

In practice interest rate differentials are a poor unbiased predictor of future exchange rates.

Factors other than interest differentials influence exchange rates such as government intervention in foreign exchange markets.

Expectations theory

The expectations theory claims that the current forward rate is an unbiased predictor of the spot rate at that point in the future.

If a trader takes the view that the forward rate is lower than the expected future spot price, there is an incentive to buy forward. The buying pressure on the forward raises the price, until the forward price equals the market consensus view on the expected future spot price.

In practice, it is a poor unbiased predictor - sometimes it is wide of the mark in one direction and sometimes wide of the mark in the other.

Four-way equivalence

The four theories can be pulled together to show the overall relationship between spot rates, interest rates, inflation rates and the forward and expected future spot rates. As shown above, these relationships can be used to forecast exchange rates.

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