For more information
Call 1-800-351-0222
Call 1-800-351-0222
PROJECTING FOREIGN CURRENCY VALUES.
Term Paper ID:30660
Essay Subject:
Discussion of models to forecast currency exchange rates in the futures market.... More...
11 Pages / 2475 Words
14 sources, 18 Citations,
APA Format
$44.00
More Papers on This Topic
Paper Abstract:
Discussion of models to forecast currency exchange rates in the futures market. Reviews three major models: Purchasing power parity (PPPM), account balance (CABM), portofolio balance (PFBM). Two newer models: random walk (RWM), Fischer effect (IFEM). The hypothesis and appeal of each model. Theoretical validity of the models. Usefulness as tools for monetary management.
Paper Introduction:
PROJECTING FOREIGN CURRENCY VALUES
Introduction
Participants in foreign exchange markets also deal for future values. Such dealing composes the forward markets or futures markets for currencies (Lu, 1997). Active forward markets exist for a few heavily traded currencies and for several time intervals corresponding to actively dealt maturities in the money market.
Risk management has been the traditional role of the futures markets. Traders, as an example, use currency futures to protect (hedge) themselves against fluctuations in exchange rates that may be detrimental to their profit margins. A United States trader who needs foreign currency for a business transaction in six months could sell a futures foreign currency contract for th
Text of the Paper:
The entire text of the paper is shown below. However, the text is somewhat scrambled. We want to give you as much information as we possibly can about our papers and essays, but we cannot give them away for free. In the text below you will find that while disordered, many of the phrases are essentially intact. From this text you will be able to get a solid sense of the writing style, the concepts addressed, and the sources used in the research paper.
In this model, the assumptionis that exchange rates adjust in a way that insures that, subsequent toconversion into another currency, a currency in question will purchasegoods and services in a foreign country equivalent to that which it couldpurchase in the domestic economy (Canner & Kilian, 2 1). In such a situation, the CABM model becomesalmost useless as tool for monetary management (Sheffrin & Bergin, 2 ). Estimating the rationalexpectations model of speculative storage. A history of economic theoryand method. (2 , April). There have been no means developedto accurately predict how long the time will be in which creditor countrieswill continue to absorb debt from a country in current account deficit.Thus, while current account deficits will likely cause a country's currencyexchange rates to return to equilibrium over the long-term, the long-termmay turn out to be 2 -years. Hu, S-W., Lai, C-C., & Wang, V. The PPP hypothesis states that the percentage exchange ratedepreciation is equal to the difference between domestic inflation andforeign inflation. In the real world, such priceseries are not available. Risk management has been the traditional role of the futures markets.Traders, as an example, use currency futures to protect (hedge) themselvesagainst fluctuations in exchange rates that may be detrimental to theirprofit margins. Thisassumption requires that rational-expectations models consider only meanexpectations and ignore the fact that probability distributions are alsoinvolved (Michaelides & Ng, 2 ). The following discussionsreview these models for the projection of currency exchange rates. When the IFEM is applied to theinternational currency market, the implication is that, on an uncoveredbasis, the differential interest returns earned by moving funds from lowerto higher rate international currency deposits are offset by equal, butopposite, changes in the spot exchange rate. There remains a significant question as to the ability of the RWM toprovide robust predictions of currency exchange rate changes in othercircumstances. One major problem is the absence ofempirical data to support the assumption that all players will act in thesame manner, even if they have access to the same information, and havesuch access at the same time. 2. If after six monthsthe United States dollar depreciated relative to the foreign currency, thetrader would incur losses in the spot market, but gains from the futurescontract offset those losses exactly. That this rational-expectations explanation of economic and financialphenomena has not satisfactorily explained past developments in currencyexchange rates does not appear to bother the proponents of the rational-expectations theory. Interest rates,exchanges rates and present value models of the current account. It furtherassumes that shifts in trading patterns will cause changes in the relativerates of inflation between countries, which, in turn, will maintain a long-term equilibrium in currency values (McDonald, 1995). (1999, Spring). Incurrency exchange rate applications, the model uses the current spot rateas the predictor of all future spot rates. The relative PPP hypothesis will still hold, however, if overallprices are homogeneous to a degree of one. The restrictive character of the absolute PPP hypothesis issuch that even if it were possible to construct prices in the mannersuggested by the hypothesis, the existence of transportation costs andother impediments to trade would interfere with the functioning of thehypothesized process. One example of this problem was evident in the inability ofthe model to predict the declining value of the United States dollar inearly-1986. Although there exist many models toforecast and manage foreign exchange rate changes, three models havedemonstrated staying power. Michaelides, A., & Ng, S. Journal of Management in Engineering, 16(3), 4 -46. All individuals make guesses concerning the future based onthe best available information at the time of making such guesses. Dumas, B., & Solnic, B. The same theory underlies all of the versions ofthe PFBM. Thus,the reasoning is that only those currency exchange rates that will maintaina country's current account in balance are sustainable over the long-term(Paek, 2 ). Simple vs. 3. (2 , May-June). The proponents of the rational-expectations explanation of the currency-exchange rate changes hold thatthe only way in which changes occur in the economy is for changes in theexpectations of the players to occur. (1995, September). Linear, non-linear and essential foreignexchange rate prediction with simple technical trading rules. A Review of Models for the Prediction of Forward Currency Values Of the many models developed to forecast and manage foreign exchangerate changes, three models have demonstrated staying power. Journal ofInternational Economics, 47(1), 91-112. Thus, demand never exceeds supply, becausewhatever the exchange rate is at a given point in time is the equilibriumrate, and disequilibrium does not occur, because those conditions thatoccur are those that are to be expected. International Monetary Fund Staff Papers, 42(1), 8 -1 7. Rational-expectations theory assumes thatall individuals will react in exactly the same manner, if they have accessto the same set of data (also assumed by the rational-expectations theory). R. The RWM, thus,could just as easily prove to be disastrous as it could be satisfactory inthe short-run.International Fisher Effect Model The logic of the International Fisher Effect (IFEM) model is that thenominal rate is the sum of the real rate plus expected inflation over thecourse of the lending period. Journal of Finance, 5 (2), 445-479. On the other hand, if the dollarappreciated relative to the foreign currency, the trader would incur lossesin the futures market that would exactly offset gains in the spot market.Thus, in a typical hedge, the gains or losses tend to offset each other(Kapila & Hendrickson, 2 1). Tests of the PPP hypothesis requirethe selection of appropriate data sets for the determination of relativeprices. EconomicJournal, 11 (463), 535-559. Journal of Econometrics, 96(2),231-267. Zhou, S., & Mahdavi, S. The problem lies in the occurrenceof dramatic changes in international economic phenomena. The failure, however, has been the subject ofsignificant criticism by other economists and financial theorists.Random Walk Model The random walk model (RWM) is a univariate time-series model. Paek, J. These modelsare (1) the purchasing power parity (PPPM) model, (2) the current accountbalance (CABM) model, and (3) the portfolio balance (PFBM) model.Additionally, the random walk model (RWM), and the international Fischereffect model (IFEM) have gained some recent acceptance.Purchasing Power Parity Model The basis of the PPPM is a contention that relative rates of inflationdetermine long-range exchange rate changes. Thus,an increase in the domestic price level in one of the two countries shouldresult in a proportionate depreciation of the exchange rate between the twocountries. Conclusion None of the models is perfect. (1997, February 7). The rational-expectations model of currency exchange rates holds thatexcess supply does not exist. Wall Street Journal, C15. Monetary announcementsand commodity price dynamics: A portfolio balance model. Thus, consumer price indexes (CPIs) and producerprice indexes (PPIs) typically represent prices in the testing of the PPPhypothesis. New York: McGraw-Hill. Faruqee, H. (1996, Summer). Such factors distortanticipated interactions of macroeconomic factors affecting currencyexchange rates. Significant among suchpreferences are political factors, and expected actions on the part ofmonetary authorities in deficit countries. When the willingness to absorb added debt ends, theexchange value of the deficit country's currency will be decline. As the RWM bases predictions of the futureon past and current measures, it is not surprising that the model attainedhigh levels of predictive accuracy in the early- and mid-198 s using datapertaining to the United States dollar. F. If there is nolong-run relationship between the exchange rate and relative prices, theresidual series also is non-stationary. References Canner, M., & Kilian, L. Rational-expectations theory provides many of themissing parts in quantitative theories in economics. Ekelund. This approach holds that anincrease in the money supply should leave equilibrium relative pricesunchanged and should increase all prices by the same amount (Malliaropulos,1998). (2 , June). In this context, the changesin the spot exchange rate reflect the nominal interest rate in the IFEM,while the differences in the interest rates earned on the two internationalcurrency deposits reflect the IFEM's expected rate of inflation. Assumptions such as those above discount the effects of pastbehavioral patterns that may be a significant part of the backgrounds ofindividuals, and they ignore the potential for psychological influences indecisions made by individuals. Long-run analyses tend to support the PPP hypothesis; however, such isnot the case with short-run analyses. The condition of absolute PPP usually involves a two-country settingin which the two countries each produce a range of homogeneous traded goodswherein the concept of a single price holds for each of the goods. When applied in a currency exchange models, random walk theory worksin the same manner as it works in a stock price model. Active forward markets exist for a few heavily tradedcurrencies and for several time intervals corresponding to actively dealtmaturities in the money market. Thus, it is, at once, obvious thatrational-expectations models work only with central tendencies, and theunity in expectations assumed by the rational-expectations theory simplydoes not exist in the real world. Projecting foreign currency values Introduction Participants in foreign exchange markets also deal for future values.Such dealing composes the forward markets or futures markets for currencies(Lu, 1997). Problems in the applicationof the portfolio balance model arise in the projection of asset holdingpreferences. Ideally, a price series consisting of the prices of homogeneousinternationally traded goods is desirable. Journal of Management inEngineering, 17(4), 186-211. An assumption that such factors remain constant overtime, however, permits the absolute purchasing power parity hypothesis towork. If there is a long-runrelationship between an exchange rate and relative prices, the appropriatemethod for the validation of the relationship is cointegration analysis(Canner & Kilian, 2 1).Current Account Balance Model The current account balance model (CABM) relies on surpluses anddeficits in a country's international current account balance as theprimary variable in the determination of currency exchange rates. B., & Hébert, R. Most of the studies have attempted to explain themovements of the United States dollar during a period in which its exchangevalue continuously increased. AmericanEconomist, 41(3), 71-78. (2 1, October). Lu, B. All individuals have sufficient information concerning thecauses of future events upon which to base their guesses. The purchasing power parity model hasthe greatest level of acceptance. While there is likely a great deal of theoretical validity in theCABM, the problems lie in application. This model also assumes that exchange rates will fluctuate withrespect to relative rates of price inflation between countries. (1999, February). Size distortions of tests ofthe null hypothesis of stationarity: Evidence and implications for the PPPdebate. Random walk refers tothe process of determining whether or not a statistical pattern is presentin a particular dynamic activity, or whether movements within the activityare random (Gencay, 1999). International stock returndifferentials and real exchange rate changes. (1995, June). As each of these measures typically include non-traded goods,however, tests of the hypothesis frequently do not attain the degree ofsymmetry and proportionality desired (Dumas & Solnic, 1995). These models are the purchasing power paritymodel, the current account balance model, and the portfolio balance model.Additionally, the random walk model and the international Fischer effectmodel have gained some degree of acceptance. The essential assumption in rational-expectations theory is that allplayers in the markets will act on this information in the same way. Without suchestimates, meaningful assessments of exchange rate level are not possible.These difficulties stem from (1) the use of different measure in inflationin various countries, and (2) the selection of a base period for analysis.Lastly, the problems associated with the use of the PPPM involve themodel's inability to account for factors other than inflation, which alsoaffect currency exchange rates (Zhou & Mahdavi, 1996). In theinternational currency application, a constant reflects the real interestrate (Ekelund & Hébert, 1998). generalizedinterest rate and purchasing power parity models of exchange rates.Quarterly Review of Economics and Finance, 36(2), 197-218. If the variables are all first-order, non-stationary in the test ofthe PPP hypothesis, the integration is an order of one. In actual practice, there are several versions of theportfolio balance model. Exchange rate riskmanagement in international construction ventures. The model assumes that international investors willdiversify their holdings among a number of currencies, as a means ofreducing risks. Rational-expectationstheory is based upon assumptions that (Michaelides & Ng, 2 ): 1. R. Journal of InternationalMoney and Finance, 17(3), 493-512. Long-run determinants of the real exchangerate. A restructuring of the hypothesis states that thechange in the real exchange rate, conditional on relative PPP holding, willresult in the logarithmic real exchange rate change equaling zero (Faruqee,1995). Like the PPPM, however, the CABM may be effective within aquasi-regulated system, such as the European Monetary System (Sheffrin &Bergin, 2 ).Portfolio Balance Model The portfolio balance model (PFBM), unlike the current account balancemodel, attempts to explain currency exchange rate changes in terms of assetholding preferences. The PPPM has a strong theoretical appeal. (5th ed.). A United States trader who needs foreign currency for abusiness transaction in six months could sell a futures foreign currencycontract for the same amount maturing in six months. That the modelattained high levels of success in the explanation of currency exchangerate changes in the last few years is likely the result of the datasubjected to analysis. Sheffrin, S. It is one thing to recognize that asset holding preferencesaffect currency exchange rates. MacDonald, R. (1995, March). Running a profitable constructioncompany. The differences among the versions are in the varying ways inwhich prices are treated (Hu, Lai, & Wang, 1999). The world price of exchange raterisk. Malliaropulos, D. All individuals have access to the same information, andhave this access at approximately the same point in time, and that allindividuals will act on this information in a rational (predictable)manner. Thebasis of this model is an assumption that an equilibrium currency exchangerate will maintain a balance in a country's current account, after allowingfor short-term fluctuations resulting from the effects of business cyclesand trade barriers. One major reason for the failure of the CABM model to accuratelypredict the time required for a return to equilibrium values is that itfails to account for asset holding preferences. One of the problemsassociated with use of the PPPM is the technical difficulty involved inderiving acceptable estimates of equilibrium exchange rates. Underlying this model is the theory that countriesrunning current account deficits over an extended period of time willeventually become debtor countries, and that such deficits can persist onlyas long creditor countries are willing to absorb added debt from thecountry in deficit. (1998). (2 1, October). Applications of the PFBM model place great reliance on the theory ofrational-expectations. Long-run exchange rate modeling.International Monetary Fund Staff Papers, 42(3), 437-489. Dollar achieves another high against theyen. (1998, June). H. Participants in currency the futures market require some method ofprojecting currency exchange rates. Nevertheless, for short-term projections, the RWM may prove insome periods to be quite satisfactory. Gencay, R. M., & Bergin, P. Kapila, P., & Hendrickson, C. The PFBM recognizes that a current account deficit for a country canpersist over an extended time, as long as the amount of a currency suppliedthrough a current account deficit is equal to the quantities of thatcurrency demanded by international investors. It is quite another, however, to makeaccurate predictions of what these preferences will be, and how long theywill persist Hu, Lai, & Wang, 1999). Some recent studies have foundthe RWM very robust in the explanations of currency exchange rate changes,while others have found the model severely lacking. W. Journal of International Money and Finance, 2 (5), 639-64 .
If this paper is not what you are looking for, you can search again:
or
We can write a Custom Essay just for you.
Browse Essays by Subject