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Chapter 6: International Parity Relationships and Forecasting Foreign Exchange Rates

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Chapter 6: International Parity Relationships and Forecasting Foreign Exchange Rates

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Another parity condition we often encounter in the literature is the Fisher effect

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analyzes the past behavior of exchange rates for the purpose of identifying “patterns”

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Reasons for Deviations from Interest Rate Parity

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Reasons for Deviations from Interest Rate Parity

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Current forward exchange rate can be viewed as the market’s consensus forecast of the future exchange rate based on the available information (It) if the foreign exchange markets are efficient

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Current forward exchange rate can be viewed as the market’s consensus forecast of the future exchange rate based on the available information (It) if the foreign exchange markets are efficient

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All relevant information is already reflected in the current exchange rate.

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All relevant information is already reflected in the current exchange rate.

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Includes factors such as money supplies, inflation rates, trade balances, and output growth.

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If the exchange rate follows a random walk and all information is already reflected in the current rate, the expectation of the future exchange rate is considered to be equal to the current exchange rate 

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If the exchange rate follows a random walk and all information is already reflected in the current rate, the expectation of the future exchange rate is considered to be equal to the current exchange rate 

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projects them into the future to generate forecasts.

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Based on the premise that history repeats itself

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At odds with the efficient market approach

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it does not use the key economic variables, like money supplies or trade balances, for purpose of forecasting

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Two examples of technical analysis:

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The fundamental approach uses various formal models of exchange rate determination for forecasting purposes. 

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The fundamental approach uses various formal models of exchange rate determination for forecasting purposes. 

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For example, the monetary approach to exchange rate determination suggests that the exchange rate is determined by three independent (explanatory) variables: (i) relative money supplies, (ii)relative velocity of monies, and (iii) relative national outputs.

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Moving average crossover rule

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Head-and-shoulders pattern

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International Fisher effect (IFE)

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Eun và Sabherwal (2002)

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Beckmann and Czudaj (2017)

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Forward expectations parity (FEP)

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As long as there are nontradables (for example, haircuts, housing, etc.), PPP will not hold in its absolute version

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As long as there are nontradables (for example, haircuts, housing, etc.), PPP will not hold in its absolute version

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If PPP holds for tradables and the relative prices between tradables and nontradables are maintained, then PPP can hold in its relative version

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If PPP holds for tradables and the relative prices between tradables and nontradables are maintained, then PPP can hold in its relative version

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One can thus formulate the monetary approach in the following empirical form:

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One can thus formulate the monetary approach in the following empirical form:

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s=α+β1(m − m*)+β2(v − v*)+β3 (y* − y)+u (6.19)

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Generating forecasts using the fundamental approach would involve three steps

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Generating forecasts using the fundamental approach would involve three steps

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Estimation of the structural model like Equation 6.19 using historical data to determine the numerical values for the parameters such as α and β’s.

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Estimation of future values of the independent variables like (m − m* ), (v − v ), and (y − y).

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Substituting the estimated values of the independent variables from Step 2 into the estimated structural model obtained from Step 1 to generate the exchange rate forecasts.

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It is virtually impossible for banks in general to outperform the random walk model. However, some banks perform significantly better than the random walk model, especially in the long run.

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analyzed monthly survey data spanning the period from 1986 to 2015

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that provided 3-, 6-, and 12-month ahead exchange rate forecasts for four major currencies against the U.S. dollar.

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professionals have a hard time predicting exchange rates

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Currency carry trade involves buying a high-yielding currency and funding it with a low-yielding currency, without any hedging

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Currency carry trade involves buying a high-yielding currency and funding it with a low-yielding currency, without any hedging

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Interest Rate Parity and Exchange Rate Determination

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Interest Rate Parity and Exchange Rate Determination