Essay Structure

The challenges in forecasting the exchange rate in the short run and the long run.

Intro

Brief intro on exchange rates

Body:

Short-Run Approach

Long-Run Approach

Challenges to Short-Run

Challenges to Long-run

Conclusion

References

Appendix

I Require help in doing the long run approach in around 400 word limit

Cheers

International Bond and Currency Markets C39SM Bond and Currency Markets Other Approaches to Exchange Rate Forecasting Other Approaches to Forecasting Future Exchange Rates. The PPP is the best known model for long term exchange rate determination, however not for forecasting future exchange rates in the short-run. In the short horizon completely other factors may determine the foreign exchange rates movements. Both long- and short-term strategies should be used. Other popular approaches: Balance of Payments Approach Asset Market Approach Market Microstructure Approach Technical Analysis Econometric methods 1. Balance of Payments Approach The balance of payments tracks all financial flows crossing a country's borders during a given period (a quarter or a year). It is not an income statement nor a balance sheet. The Balance of Payments (BoP) records all transactions between a given country and the Rest of the World (often referred to as RoW, for brevity). Balance of Payments Approach This approach focuses on relationship between balance of payments and exchange rates. Any trade deficit has to be matched by surplus in capital account (inflow of capital from abroad). Use of econometric models to predict impact of import/export imbalances on capital flows and exchange rates. Balance of Payments Approach The convention is that inflows of currency, such as result from exports, are recorded as positive items, while outflows, such as result from imports, are recorded as negative items. Like all cash accounts, the balance for a given country in any period must be zero. Balance of Payments Approach Three accounts make up the BoP: current account capital account; and official reserve account. Current Account Covers all current transactions that take place in the normal business of residents of a country. Dominated by the trade balance, the balance of all exports and imports. Made up of: Exports and imports (trade balance) Services Income Current transfers Current Account (cont.) It also covers: Services (such as services in transportation, communication, insurance and finance). Income (interest, dividends and various investment income from cross-border investments). Current transfers (flows without quid pro quo compensation). A current account deficit is not necessarily a bad economic signal as long as nonresidents are willing to offset it by investment flows. Capital Account Covers investments by residents abroad and investments by nonresidents in the home country. It includes: Direct investment made by companies. Portfolio investments in equity, bonds and other securities of any maturity. Other investments and liabilities (such as deposits or borrowing with foreign banks and vice versa). Capital account also includes unrequited (unilateral) transfers corresponding to capital flows without compensation such as foreign aid, debt forgiveness and expropriation losses. This is typically a very small account with a misleading title. Official Reserve Account The third part of the BoP, the official reserve account, reflects changes in the government's holdings of foreign currency or loans to foreign governments. The balance in this account is denoted OR. Then it must always be the case that: CA + KA + OR = 0 Balance of Payments Approach An analysis of balance of payments provided the first approach to the economic modelling of the exchange rate. Check the component groups including the current account, capital account and official reserves account. An imbalance in some account could lead to a depreciation or appreciation of the home currency. Notes: (1) These relations must hold, as an accounting identity, but measurement problems and errors mean that it does not always appear to hold exactly. The term NE (net errors and omissions) in the capital account ensures that everything balances as it should (similar terms can be found in the national accounts for all countries). (2) Some countries try to estimate their international accounts by recording all transactions, while others use a sampling approach. Both approaches are subject to error, especially in regard to the measurement of capital flows, services transactions, etc. Hence the need for the term NE. Notes (cont.): (3) Take care with the sign conventions in these accounts. The official reserves account often causes confusion here. E.g. for the UK, if the government has to sell foreign currency to accommodate a deficit in the trade accounts, there is an inflow of pounds and this is recorded as a positive contribution to OR - thus a fall in reserves of foreign currency is recorded as an increase in OR. Notes (cont.): (4) The fact that the BoP accounts always balance does not mean that the BoP is always in equilibrium Example: Suppose that for a given country we have: CA = 125 KA = -130 OR = 5 Currency unit: billion USD Now, let's consider the links between the BoP and exchange rate movements. BoP and exchange rate movements Most straightforward approach, especially for countries where there are restrictions on capital flows is to start from trade flows. If there is a trade deficit that cannot readily be covered by inflows of (private sector) capital, then expect the currency to devalue. If there is a trade surplus not offset by outflows of capital, then expect the currency to appreciate. Effect of such changes then depends on responsiveness of exports and imports to changes in the exchange rate. Empirically, often a J-curve effect exists. The J Curve BoP and exchange rate movements The curve shows that after a devaluation, the trade balance often worsens even more before it starts to recover. This is because trade flows take time to adjust as existing commitments still have to be fulfilled. In practice, study of trade flows turns out not to help much in explaining the course of exchange rates. We understand moderately well how a devaluation or revaluation of the currency influences trade flows in the subsequent 2-3 years, but in the long term, the connection between trade flows and the exchange rate seems to be quite weak. So what other explanations can we find? An alternative way of thinking about exchange rates is the Assets Market Approach. 2. Asset Market Approach This approach claims that the exchange rate is the relative price of two currencies, determined by investors' expectations about the future, not by current trade flows. \"News\" (unexpected information) about future economic prospects should affect the current exchange rate. Expectations concerning the future macroeconomic situation indicate future expected capital flows. Asset Market Approach Consider a one-time sudden and unexpected increase in the domestic money supply that will lead to higher home inflation. The long-run exchange rate effect is a depreciation of the home currency so that purchasing power parity is maintained as the percentage increase in the price level matches the percentage increase in the money supply. Given sticky goods prices, the short-run exchange rate effect is an immediate drop in the real interest rate and more depreciation of the currency than the depreciation implied by purchasing power parity. Exchange Rate dynamics 3. Market Microstructure Approach Methodology used to explain the exchange rates movements in a very short horizon. What drives the exchange rates is the order flow generated by the investors. Order flow is a record of all transactions, which investors want to make in the nearest future. Market Microstructure Approach In the market microstructure approach long term is not relevant. Therefore all the variables used in the theories and parities, which hold in the long run, are ignored. Instead, the analysis is focused on the demand and supply of currencies as indicated by the order flow data. A very successful methodology. Market Microstructure Approach Empirical evidence suggests that order flow is a very good predictor of the exchange rates (direction) of change in the nearest time. Problems: Order flow data is not publicly disclosed It is a proprietary information of individual banks and market dealers Can not be easily used for forecasting 4. Technical Analysis Bases predictions solely on price information and ignores underlying economic variables Technical analysis looks for the repetition of specific price patterns. It is not very quantitative Once the start of such a pattern has been detected, it automatically suggests what the short-run behaviour of an exchange rate will be. Technical analysis has long been applied to commodity and stock markets. The application to the foreign exchange market is a more recent phenomenon. Technical Analysis Commonly used methods are: Trading rules Analysis of repeating patterns Analysis of chart formations Methodology useful for short-term forecasts, although there is also an evidence that it works in the long horizon investments. Computer Methods in Technical Analysis Trading rules Moving averages The aim is to smooth erratic daily swings of exchange rates in order to signal major trends. Filter rule (can be optimised to obtain the best results) buy signals when an exchange rate rises X percent (the filter) above its most recent trough sell signals when it falls X percent below the previous peak. Index of market momentum Analysis of repeating patterns There is an evidence in the financial literature on the cyclical behaviour of the stock prices. Interesting calendar effects were identified (i.e. January effect, Monday effect etc.) .... ....however there is a mixed evidence about their persistence over time and existence in various markets. Analysis of chart formations Look for particular patterns such as flag pennant head and shoulder camel There are a few important questions, e.g.: Are those effects consistent and do they persist over time? What happens when you consider transaction costs? Analysis of chart formations Various patterns indicating either continuation or reversal of the current trend. Very subjective and informal method of analysis. 5. Econometric Models Econometric models make it feasible to take complex correlations between variables into account explicitly. Parameters for the model are drawn from historical data. Current and expected values for causative variables are entered into the model, producing forecasts for exchange rates. Econometric Models Regression models which use: Autoregressive relationships Causal relationships involving other variables Other variables can be based on: -currency market data -other related markets data (eg. Stock market, money market etc.) -macroeconomic data from either the domestic economy or from foreign countries. Analysis involving the autoregressive relationships Analysis if the price in time t is a function of prices in time t-1, t-2, t-3, t-4, etc., i.e.: pt = f(pt-1, pt-2, pt-3, pt-4, ...) or: where: pt - price in time t 0, 1, 2, 3, - model's parameters (to be estimated) - error term Analysis involving the causal relationships Analysis if the price in time t is a function of other factors (x, y, z, etc.) in time t-1, t-2, t-3, t-4, etc., i.e.: pt = f(xt-1, xt-2, xt-3, xt-4, ...) or: where: pt - price in time t 0, 1, 2, 3, - model's parameters (to be estimated) - error term Econometric Models In particular, two following hypotheses - used in econometric modelling - have gained popularity in the recent years: heat wave effect meteor shower effect Econometric Models When estimating parameters of the models, do remember to take account of the properties of the error term (e.g. heteroskedasticity or unequal variance over time etc.) Sometimes more advanced models than simple linear regression using the Ordinary Least Squares as the estimation method have to be applied (e.g. ARCH or GARCH models). A choice of wrong statistical or econometric method may lead to false results (although the model's specification, i.e. a set of explanatory variables, may be correct). Econometric Models General procedure: 1) Check the statistical significance of estimates. If the estimated parameters 0, 1, 2, ... etc., significantly differ from zero (in statistical terms), then this result means that past prices are related to the current price. 2) Check the sign of the estimated parameters. 3) Check the magnitude of the estimated parameters. 4) Construct a trading strategy ... Two drawbacks Econometric models rely on predictions for certain key variables (money supply, interest rates) that are not easy to forecast. The structural correlation estimated by the parameters of the equation can change over time. Forecasting Performance Of The Models And Efficient Markets Theory Implications of weak-form efficiency: If the market is efficient, then this means that no gains can be made from trading based on past information. If the market is not efficient then the investment strategies exploiting past information may bring extra profits (\"above average\"). Forecasting Performance Of The Models And Efficient Markets Theory Most of the models are based on the past data (\"information from the past\"). If they are successful and have substantial forecasting power, then this would mean that the market is not efficient. Other issues to consider Central Bank Intervention Central Banks are one of the major players in the foreign exchange markets. Their motives are somewhat different from those of most other market participants. Some central banks are renowned for the active management of their foreign currency reserves, but most do not attempt to profit from trading. Central banks try to implement the monetary policy and exchange rate targets defined by their monetary authorities. What to do? The type of method used to forecast exchange rates depends on the user's motivation. A currency hedge focuses on short-term movements, while an international asset allocator cares about long-term prospects. The corporate treasurer who manages a complex international position with daily cash flows and adjustments in his foreign exposure can respond readily to technical analysis recommendations. Or one can use technical analysis to time investment sales and purchases or for currency-hedging decisions. This is not the case for money managers who tend to use economic models for their asset allocation. Summary: * Alternative approaches: Balance of Payments Approach Asset Market Approach Market Microstructure Approach Technical Analysis Econometric methods * BoP approach uses the data from current account and capital account * If there is a trade deficit, then expect the currency to devalue. * If there is a trade surplus, then expect the currency to appreciate. * In the Asset Market Approach the exchange rate is determined by expected trade flows. * In the Market Microstructure approach the order flow drives exchange rates. * Technical analysis: Trading rules Analysis of repeating patterns Analysis of chart formations * Econometric models may use autoregressive and causal relationships