Problem Set 5 Flashcards
short term forecast motivation?
Short-term forecasts are typically motivated by a desire to hedge a receivable, payable, or dividend for perhaps a period of three months. In this case, the long-run economic fundamentals may not be as important as technical factors in the marketplace, government intervention, news, and passing whims of traders and investors. Accuracy of the forecast is critical because most of the exchange rate changes are relatively small even though the day-to-day volatility may be high.
long term forecast motivation?
Long-run forecasts may be motivated by a multinational firm’s desire to initiate a foreign investment, or perhaps to raise long-term funds denominated in a foreign currency. Or a portfolio manager may be considering diversifying for the long-term in foreign securities. The longer the time horizon of the forecast, the more inaccurate but also the less critical the forecast is likely to be. The forecaster will typically use annual data to display long-run trends in such economic fundamentals as foreign inflation, growth, and the balance of payments (BOP).
what is meant by fundamental equilibrium path?
It appears from decades of theoretical and empirical studies that exchange rates do adhere to the fundamental principles and theories. Fundamentals do apply in the long term. There is, therefore, something of a fundamental equilibrium path for a currency’s value. It also seems that in the short term, a variety of random events, institutional frictions, and technical factors may cause currency values to deviate significantly from their long-term fundamental path. This is sometimes referred to as noise. Clearly, therefore, one might expect deviations from the long-term path not only to occur, but also to occur with some regularity and relative longevity. The long-term equilibrium path of the currency—although relatively well defined in retrospect—is not always apparent in the short term. The exchange rate itself may deviate in something of a cycle or wave about the long-term path.
what is noise?
short term votility around the long-term path
describe the asset market approach
The asset market approach, sometimes called the relative price of bonds or portfolio balance approach, argues that exchange rates are determined by the supply and demand for financial assets. Shifts in the supply and demand for financial assets alter exchange rates. Changes in monetary and fiscal policy alter expected returns and perceived relative risks of financial assets, which in turn alter rates. This differs from the balance of payments approach argument that the equilibrium exchange rate is found when the net inflow (outflow) of foreign exchange arising from current account activities matches the net outflow (inflow) of foreign exchange arising from financial account activities
what does the asset market approach assume?
The asset market approach assumes that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations or drivers.
examples of investment considerations or drivers (for asset market approach)
- Relative real interest rates
- Prospects for economic growth and profitability
- Capital market liquidity
- A country’s economic and social infrastructure is an important indicator of that country’s ability to survive unexpected external shocks and to prosper in a rapidly changing world economic environment.
- Political safety
- The credibility of corporate governance practices is important to cross-border portfolio investors
- Contagion is defined as the spread of a crisis in one country to its neighboring countries and other countries that have similar characteristics—at least in the eyes of cross-border investors. Contagion can cause an “innocent” country to experience capital flight with a resulting depreciation of its currency.
- Speculation
what is technical analysis?
Technical analysis is the belief that the study of past price behavior provides insights into future price movements. The primary feature of technical analysis is the assumption that exchange rates, or for that matter any market-driven price, follows trends. Technical analysts, traditionally referred to as chartists, focus on price and volume data to determine past trends that are expected to continue into the future. The single most important element of technical analysis is that future exchange rates are based on the current exchange rate. Exchange rate movements, similar to equity price movements, can be subdivided into three periods: (1) day-to-day movement, which is seemingly random; (2) short-term movements extending from several days to trends lasting several months; and (3) long-term movements, which are characterized by up and down long-term trends. Long-term technical analysis has gained new popularity as a result of recent research into the possibility that long-term “waves” in currency movements exist under floating exchange rates.
how is technical analysis different from BOP?
This differs from the balance of payments approach argument that the equilibrium exchange rate is found when the net inflow (outflow) of foreign exchange arising from current account activities matches the net outflow (inflow) of foreign exchange arising from financial account activities.
what is infrastructure weakness?
Infrastructure weakness refers to situations where public services (roads, railroads, electric power, impartial judicial system, minimum corruption by politicians, adequate police and fire services, reasonable health-care systems, etc.) are dysfunctional. Lack of quality services increases the difficulty and risk of operating a business in that country, which in turn means domestic investment funds will tend to escape from the country and foreign investment funds will not enter. The flight of domestic currencies and the lack of foreign demand for the domestic currency force the exchange rate down (floating regime) or force the government to devalue (fixed exchange rate regime).
what is speculation?
Speculation contributed greatly to the emerging market crises. Some characteristics of speculation are hot money flowing into and out of currencies, securities, real estate, and commodities. (“Hot money” is a term used to describe funds held in one country’s currency that will move very quickly to another currency as soon as it is deemed weak.) Uncovered interest arbitrage caused by exceptionally low borrowing interest rates in Japan coupled with high real interest rates in the United States was a problem in much of the 1990s. Borrowing yen to invest in safe U.S. government securities, hoping that the exchange rate did not change, was popular. Governments can attempt to manage foreign exchange speculation by either direct intervention (buying or selling the domestic currency against a foreign currency) or indirect intervention (the alteration of economic or financial fundamentals, which are thought to be drivers of capital to flow in and out of specific currencies, i.e., interest rates).
