markets are in equilibrium.

The exchange rate between two currencies should equal the ratio of the countries’ price levels:

S($/£) =P$/P£

country.

• When IRP doesn’t hold, the situation also gives rise to covered interest arbitrage

  opportunities.

Transactions Costs

• The interest rate available to an arbitrageur for borrowing, ib , may exceed the rate he can lend at, il.

• There may be bid-ask spreads to overcome, Fb/Sa < F/S

• Thus

(Fb/Sa)(1 + i£b) − (1 + i$a) </= 0

Capital Controls

• Governments sometimes restrict the import and export of money through taxes or outright bans.

• If there are deviations from PPP, changes in nominal exchange rates cause changes in the real exchange rates, affecting the international competitive positions of countries. This, in turn, would affect countries’ trade balances.

• Generating forecasts using the fundamental approach would involve three steps:

Step 1: Estimation of the structural model like Equation 6.18 to determine the numerical

values for the parameters such as α and β’s.

Step 2: Estimation of future values of the independent variables like (m − m*), (v − v*), and

(y* − y).

Step 3: Substituting the estimated values of the independent variables into the estimated

structural model to generate the exchange rate forecasts.

• The downside is that fundamental models do not work any better than the forward rate model or the random walk model.

• Technical analysis first analyzes the past behavior of exchange rates for the purpose of identifying “patterns” and then projects them into the future to generate forecasts..

• Clearly it is based upon the premise that history repeats itself.

Thus it is at odds with the EMH

• Forecasting is difficult, especially with regard to the future.

• As a whole, forecasters cannot do a better job of forecasting future exchange rates than the forward rate.

The founder of Forbes Magazine once said:

“You can make more money selling financial advice than following it.”