Currency exchange rate forecasting is particularly difficult, causing investment managers to either fully hedge currency exposure, or accept the volatility.
Currencies are units of account in which asset prices are quoted. Movements in exchange rates change the value of all assets denominated in one currency relatively to all other currencies.
Perhaps even more importantly, anything that changes expectations of prices, quantities, or values within any currency can change expectations about the future path of currencies, causing an immediate reaction in exchange rates as people adjust their exposures.
Exchange rates are determined by factors influenced by trading, governments, financial systems and geographies, as well as by laws, regulations, and customs of a country.
Goods and Services, Trade and the Current Account
Trade flows: The impact of net trade flows (gross trade flows less exports) tends to be relatively small on exchange rates assuming they can be financed.
Purchasing power parity (PPP): PPP implies that the prices of goods and services in different countries should reflect changes in exchange rates. As a result, the expected exchange rate movement should follow the expected inflation rate differentials.
Current account and exchange rates: When restrictions are placed on capital flows, exchange rate sensitivity tends to increase relative to the current account (trade) balance. Current account balances will have the largest influence on exchange rates when they are persistent and sustained. However, it is not the size of the current account balance that matters as much as the length of the imbalance.
Structural imbalances in the current account can exist from (1) fiscal imbalances that persist over time, (2) demographics and trade preferences that impact savings decisions, (2) how abundant or scare resources are, (4) availability (or lack) of viable investment opportunities, and (5) the terms of trade.
Adjustments to capital flows will place substantial pressure on exchange rates. Three important considerations to look at are the implications on capital mobility, uncovered interest rate parity, and portfolio balances and compositions.
Capital mobility: The expected percentage change in the exchange rate can be computed as the difference between nominal short-term interest rates and the risk premiums of the domestic portfolio over the foreign portfolio:
E(%ΔSd/f) = (rd – rf ) + (Termd – Termf ) + (Creditd – Creditf ) + (Equityd – Equityf ) + (Liquidd – Liquidf )
When there is a relative improvement in investment opportunities in a country, the currency initially tends to see significant appreciation but “overshoots” and eventually depreciates.
There are three phases of the response to stronger investment opportunities: (1) the exchange rate will initially significantly appreciate, (2) following an extended level of stronger exchange rates in the intermediate term, investors will start to expect a reversal, and (3) the exchange rate in the long run will tend to start reverting (depreciate) once the investment opportunities have been realized.
Uncovered interest rate parity (UIP): UIP states that exchange rate changes should equal differences in nominal interest rates. UIP implies that in the previous equation, only the interest rate differential matters and not the premium differentials.
When capital flows into a country given exchange rate differentials, this is referred to as hot money. Hot money creates monetary policy issues. First, central banks’ ability to use monetary policy effectively is limited. Second, firms use short-term financing to fund long-term investments, which increases financial market risk. Third, exchange rates tend to overshoot, creating business disruption. Central banks may try to counter the effects of hot money flows through intervention in the currency markets, including selling government securities or maintaining interest rate targets.
Portfolio balance and composition: Strong economic growth in a country tends to correspond to an increasing share of that country’s currency in the global market portfolio. Investors need to be induced to increase their allocations to that country and currency, which weakens the currency and increases the risk premiums. However, a few factors could mitigate this impact:
Investors tend to have a strong home country bias, which leads them to absorb a larger share of the new assets.
If growth is due to productivity gains, investors may fund it with financial flows and foreign direct investment.