Exchange Rate Determination

INTRODUCTION

The purpose of this dissertation is to evaluate the efficacy of fundamental financial principles with respect to exchange rate determination. To achieve this, this essay examines exchange rate determination from a variety of different viewpoints. These issues involve contrasting forecaster performance with realised future values, the implications of short term extreme volatility a comparison of technical and fundamental forecasts and a case study analysis of the Asian Currency Crisis. By no means a conclusive list, these issues are considered to be both sufficient and necessary for an evaluation of the central premise. To facilitate this analysis this dissertation is broken up into five key sections; an introduction and overview of the fundamental determinants of exchange rates, details of the data collected and the rationale for the examination, a results section that presents and explains the figures and ultimately some discursive and concluding remarks.

FUNDAMENTALS OF EXCHANGE RATE DETERMINATION

The current paradigm for exchange rate determination is a tri- partite composite of three contrasting but complementary theories. These theories are; International Parity Conditions, Balance of Payments and the Asset Market Approach[1]. Although the following section will analyse these approaches separately it is important to appreciate that they are intended to operate in concert.

International Parity Conditions

The international parity condition essentially forecasts exchange rates by utilising the no arbitrage argument. That is where there is disequilibrium the actions by arbitrageurs will force the price back into an equilibrium exchange rate as they attempt to profit from a discrepancy. Developed by Gustav Cassel in 1920 the international parity condition is predicated on the law of one price. That is, in two different yet frictionless markets, the price of a good or service should remain the same (Eiteman et al, 2008). It can be...