Exchange Rate Determination

Exchange Rate Determination (Note 07; Ch 7)

Market Efficiency

Fundamental Analysis

Fundamental Factors

Fundamental Models

I. Market Efficiency

A market is efficient if prices reflect available information (i.e., requires people to process information and form reasonable expectations).

Degrees of Informational Efficiency

a. Weak-form efficiency: prices reflect historical information only.

b. Semi strong-form efficiency: prices reflect historical and publicly available information.

c. Strong-form efficiency: prices reflect historical, public and private information.

Generally, empirical evidence finds that the market is weak to semi-strong form efficient.

What does it mean by FX forecasting if FX markets are efficient?

Suppose market is semi-strong: exchange rate has already reflected all relevant information, and will only change when new information is revealed. Since information is unpredictable, the exchange rate will be random over time.

II. Fundamental Analysis

Study the basic economic factors which are important to exchange rate determination

1. The components from the international parity conditions (i.e., forward rates, relative inflation rates, and relative interest rates)

2. Examine the underlying factors behind the fundamentals (i.e., relative money supplies, BOP positions, central bank behavior)

There are three general approaches for exchange rate determination:

1) International parity conditions: see the chapter/notes for international parity conditions.

2) Asset approach: emphasis on investment and capital flow of the currency

The extent that investors are willing to hold foreign claims depends on relative interest rates and a country’s financial outlook (economic prospects, profitability); liquidity (can you sell assets quickly at fair market value?) political stability; the credibility of corporate governance

3) Balance of Payments...