Deck 3: Foreign Exchange Determination and Forecasting  

Question 1

In 1995, the Thai baht is pegged to a basket of currencies. Assume that the baht exchange rate is set
at 25 baht per U.S. dollar. Thailand is experiencing rapid economic growth, with extensive ongoing foreign investment. Consumer price index (CPI) inflation in Thailand is somewhat higher than in the United States, and the current account in Thailand is in deficit. Nevertheless, Thailand has no problem maintaining its fixed exchange rate with the dollar.
a. Explain why the Thai baht does not depreciate as suggested by purchasing power parity (PPP).
b. Two years later, prospects for economic growth are much lower and investors are worried about the political and financial uncertainties in Thailand. Explain why the Thai baht depreciates strongly against the U.S. dollar.

Answer 1

a. PPP does not take into account Thailand's important growth potential. As suggested by the asset market approach, this growth potential attracts large inflows of capital through foreign investment in the country. This results in an increased demand for the home currency, which is consequently strengthened. The current account deficit is offset by a financial account surplus. Also, productivity gains in Thailand allow it to sustain a real appreciation of the baht. Both reasons explain why the Thai baht does not depreciate as suggested by PPP.
b. Two years later, prospects for economic growth are much lower. Moreover, investors are worried about the political and financial uncertainties in Thailand. As a result, the demand for the home currency falls. Then, the spot exchange rate adjusts to inflation differential between the two countries. This explains why the Thai baht depreciates against the U.S. dollar.

Question 2

In the 1970s, France had a dual exchange rate system in place for its residents. All business trade transactions took place at the official, or "commercial," exchange rate (say, 5 francs per U.S. dollar). All foreign investments by French industrial corporations were subject to prior government authorization. The regulation was even stricter for French financial institutions or private residents. They were not allowed to transfer currency abroad. French tourists could not take abroad more than FF 5,000 (or its equivalent in foreign currency) per year. French residents could buy foreign securities, but had to use a special "financial" rate to purchase these foreign currencies. Basically, the supply of foreign currency assigned to "financial" francs was fixed. To buy foreign securities, residents had to use the proceeds of the sales of foreign securities by other French residents. This led to a separate market for the "financial" franc with a different exchange rate. Foreign income and dividends paid were repatriated at the "commercial" franc rate and did not increase the supply of "financial" currency available. By contrast, foreigners were free to buy and sell French securities at the "commercial" rate, but they were not allowed to borrow francs.
a. Explain why this type of control imposed on French residents helps defend the French franc, which was periodically under devaluation pressure.
b. Would you expect the financial exchange rate to be higher or lower than the commercial rate?

Answer 2

a. These controls made speculation against the French franc less attractive for residents. They would have to pay a premium if they wanted to buy foreign currencies, using a financial rate
that would be higher than the commercial rate. With the supply of foreign currency assigned to financial francs being fixed, there was indeed no possibility for any speculation against the French franc on the part of residents. On the other side, foreigner speculation strategies were reduced by the fact that they could not borrow francs.
b. The financial franc exchange rate (e.g., 6 francs per dollar) is likely to be higher than the commercial franc exchange rate (e.g., 5 francs per dollar). Controls make it difficult to buy foreign-currency securities and the supply of financial francs is fixed, while the demand for foreign investment grows over time with general growth. The difference between the two rates is likely to increase in periods where the franc is under speculative attacks.

Question 3

An asset manager has conducted an extensive econometric study and proposes a forecasting model. He has found that a currency with a high interest rate tends to appreciate relative to a currency with
a low interest rate. The simple forecasting model for the one-year exchange rate is that a currency should appreciate over the year by the amount of the interest rate differential quoted today. For example, if the Australian dollar exchange rate is AUD/$ = 2 and the one-year interest rates in AUD and $ are 4% and 7%, respectively, the U.S dollar should move up by 3% relative to the Australian dollar, and your forecast for the exchange rate at the end of the year is AUD/$ = 2.06.
a. What is the current forward exchange rate?
b. What type of forward transaction would you conduct to capitalize on your forecast?
c. If everyone were using your model and following your strategy, what would happen to the exchange and interest rates?

Answer 3

a. According to the interest rate parity relation, F, the current forward exchange rate, is given by: $F = 2 \frac { 1.04 } { 1.07 } = 1.9439$ AUD/$.
b. To capitalize on my forecast for the exchange rate at the end of the year (AUD/$ =2.06), I can buy forward dollar contracts for delivery in one year (AUD/$= 1.9439).
c. If every market participant was using my model, everyone would simultaneously conduct my type of forward transaction. Hence, the current forward exchange rate would instantaneously become equal to 2.06. The spot exchange rate and the interest rates would have to move to be consistent with this forward exchange rate value.

Question 4

In the early 1990s, France and Germany had similar current and forecasted inflation rates. However, political/economic uncertainties were higher in France, where several political changes in the 1980s had led to several devaluations of the French franc. Do you expect to observe equal interest rates in the two countries? Why or why not?

Question 5

The current Swiss franc/euro rate is 1.5 francs per euro. Inflation rates are approximately 1% in Switzerland and between 1.8% and 2.2% in the various countries of the euro zone. One-year interest rates are 2% in Swiss francs and 3% in euros. What would be a natural forecast for the Swiss franc/euro exchange rate next year?

Question 6

The domestic economy seems to be overheating, with rapid economic growth and low unemployment. News has just been released that the monthly activity level is even higher than expected (as measured by new orders to factories and unemployment figures). This news leads to renewed fears of inflationary pressures and likely action by the monetary authorities to raise interest rates to slow the economy down. Why is this news good or bad for the exchange rate?

Question 7

Assume that foreign exchange rates are totally unpredictable, as some theories and empirical studies claim, so that the best prediction of the future spot rate is the current spot rate.
a. Back in 1982, would you have suggested investing in U.S. dollar bills or in German bills?
b. What about in 1992?
c. What about in 1997?
(Look at Exhibit 3.1 of the fifth edition, knowing that inflation rates were similar in the two countries.)

Question 8

Foreign companies are complaining that they are prevented from exporting to Japan by all kinds of official or unwritten impediments. Try to list some of these impediments. What are the implications in terms of using PPP to forecast the yen exchange rate?

Question 9

You believe that the U.S. dollar will strongly appreciate against the euro in the next few weeks. What action can you take?

Question 10

Project using the Web site database:
One would expect that PPP would be better verified for countries with high inflation. Look at the validity of PPP for Latin American countries relative to the United States.
$\bullet$ Take the end-of-quarter consumer price index data for a sample of high-inflation emerging countries and the United States for a period of ten years or more. For each country, divide its price index by that of the United States to obtain its relative price index.
$\bullet$ Take end-of-quarter exchange rates against the U.S. dollar.
$\bullet$ For each country, perform various statistical tests to compare the two series. For example, you can first plot them, using a common base. You can also calculate their quarterly percent variation and compare the means of the two series (average inflation differential and average depreciation of the currency). You could do a regression of the quarterly exchange rate variations on the quarterly inflation differential and look at the regression coefficients, as well as at the R-square.
$\bullet$ Do a similar calculation for some developed countries (e.g., Japan, Germany, and the United Kingdom) relative to the United States. Are the conclusions similar?

Question 11

In late 1994, it was announced that Japan's monthly current account was shrinking and that this effect could be permanent. Is this news good or bad for the Japanese yen? Why?

Question 12

The euro was introduced in 1999 as the common currency of eleven European countries (Euroland). What should happen to the inflation rates of France, Germany, and Italy after the introduction of the common currency?

Question 13

Project using the Web site database:
Take a time series of monthly exchange rates of a major currency relative to the U.S. dollar. Try to derive a technical analysis that would yield a profitable trading strategy over the period studied. For example, you could simulate various moving average strategies discussed in the text or simulate various filter strategies. Apply the strategy that seems most profitable for the previous exchange rate to other currencies. Perform the same exercise for nondollar exchange rates (for example, for the CHF/£ rate). What do you conclude?

Question 14

Paf is a country with a fixed exchange rate with the U.S. dollar, set at 0.9 pifs per dollar. The Paf government intends to defend this central parity but has no exchange controls; it can only use an interest rate policy to defend its national currency, the pif. The pif comes under severe speculative devaluation pressures because of a drop in the official reserves of Paf. The current (annualized)
one-month interest rates are 18% for the pif and 6% for the dollar.
a. What type of borrowing/lending action could you take to try to take advantage of a devaluation of the pif?
b. How much would you stand to lose if Paf is successful in defending its currency?
c. How much would you stand to gain if the pif is devalued to 1 pif per dollar within the next month?