Predicting Foreign Exchange Rates

8/6/2019 Predicting Foreign Exchange Rates

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PREDICTINGFOREIGNEXCHANGERATES



Introduction

In a rapidly globalising world, there is a growing tendency

among business firms to operate in other countries.

Setting up of subsidiaries abroad to look for new business

opportunities is one of the most common step taken by

them during the present day scenario. For this they raise

capital from many countries. There is a huge amount of

risk associated with the foreign currency markets. So, itis essential for management to understand the foreign

currency market as well as its trends to make such

investment decision.

Each country has its own currency. All the business

transactions within that country are preferred to be

undertaken in the local currency. Foreign exchange

market is a forum where the currency of one country is

traded for the currency of other country. So, it is boon for

the international firms which can buy or sell the local

currency in lieu of the currency which they usually to

carry out local business transactions. These business

transactions can include payment of imports, exports,

foreign direct investments.

Foreign exchange markets are the largest financial

markets of the world. They deal with large volume of funds as well as large no. of currencies. There is large

network of commercial banks, investment bankers and

brokers involved in the foreign exchange market.

Business firms usually buy and sell securities authorised

dealers to avoid speculation. They together synchronize

in such a way that this large system works.

Although there are large no. of currencies in the worldbut primarily trading is done in major currencies of the



world like US dollars, Euro, British pound sterling, French

franc, Japanese yen, Deutsche mark and Swiss franc.

There is an active market for these currencies since large

volumes of funds are traded in these currencies. Thedealings consists of large amount of financial instruments

like currency swaps , options etc. A lot of trading is also

done in futures market where in the exchange rates are

different from the spot rates. The major foreign exchange

markets are London, New York and Tokyo .

In our analysis we have tried to study the variation in the

exchange rate of two currencies , US dollar $ and theIndian rupee Rs . We have taken data for the last fifteen

years for the exchange rate of $ vs. Rs. Significant

variation can be seen in exchange rate from the plot.

There always lies a difference between the exchange

rates of different currencies . Also this exchange rate

keeps on changing with time due to a lot of reasons. Forexample, exchange rate of US $ is significantly higher

than Indian Rupee. There are several political and

economic factors that have significant effects on the

determination of exchange rates of different countries

and thus , account for the variation in exchange rates of

different currencies . They are explained below.

Inflation Rates



If two countries have differing rates of inflation, then therelative prices of goods in the two countries will change.

The relative price of goods is linked to the exchange ratethrough the theory of Purchasing Power Parity.

The Dictionary of Economics defines Purchasing Power Parity Theory as:“A theory which states that the exchange rate between

one currency and another is in equilibrium when theirdomestic purchasing powers at that rate of exchange areequivalent”.

Using this definition, we can show the link betweeninflation and exchange rates. To illustrate the link, we'lltake two fictional countries: Mikeland and Coffeeville.Suppose that on January 1st, 2004, the prices for everygood in each country is identical. Thus a football thatcosts 20 Mikeland Dollars in Mikeland costs 20 CoffeevillePesos in Coffeeville. If Purchasing Power Parity holds then1 Mikeland Dollar must be worth 1 Coffeville Peso,

otherwise we could make a risk free profit buyingfootballs in one market and selling in the other. So herePPP requires a 1 for 1 exchange rate.

Now let's suppose Coffeville has a 50% inflation ratewhereas Mikeland has no inflation whatsoever. If theinflation in Coffeeville impacts every good equally, thenthe price of footballs in Coffeeville will be 30 CoffevillePesos on January 1, 2005. Since there is zero inflation inMikeland, the price of footballs will still be 20 MikelandDollars on Jan 1 2005.

If purchasing power parity holds and we cannot makemoney from buying footballs in one country and sellingthem in the other, then 30 Coffeeville Pesos must now beworth 20 Mikeland Dollars. If 30 Pesos = 20 Dollars, thenour Peso-to-Dollar exchange rate is 1.5, meaning that itcosts 1.5 Coffeville Pesos to purchase 1 Mikeland Dollaron foreign exchange markets.

http://economics.about.com/cs/money/a/purchasingpower.htm


http://economics.about.com/od/inflationanddeflation/


















Thus, PPP tells us that if a country has a relatively highinflation rate we should see the value of its currencydecline.

The PPP theory can be expressed more comprehensivelyin the form of the following equations:-

PPPr = Spot Rate X ( 1 + rh / 1 + rf )PPPr = Spot Rate X ( Ph / Pf )

Where PPPr = purchasing power parity rate ; rh and rf arerates of inflation in the home country and the foreigncountry ; Ph and Pf are the respective price indices of thehome country and the foreign country.

Effect of inflation rates on Exchange rates can be viewedfrom a different aspect. In case the domestic inflationrate is greater than foreign inflation rate it leads to moredemand for foreign goods as they become relativelycheaper this in turn leads to more demand for foreignexchange, making it costlier. This explanation is based onthe economic law of demand and supply.

In contrast, lower domestic inflation rates will makedomestic goods cheaper. As a result, demand for exportswill increase. This will increase the supply of foreignexchange, thus appreciating the domestic currency.

These two graphs show variation of inflation

of India and USA from Jan-94 to Jan-09







Interest Rates

It is the second major factor, after Inflation which

determines the exchange rates.

Interest rates for the country are decided by the CentralBank of the country. Central Banks for India is Reserve

Bank of India and for USA is Federal Reserve Bank. By

manipulating interest rates, central banks exert influence

over both inflation and exchange rates, and changing

interest rates impact inflation and currency values.

For instance if Interest rate in India is higher than interest

rate in USA than US funds will be attracted to India aspeople will earn higher yields by investing in India than in

US. So US investors will like to invest in India and Indian

investors will keep their money in India, thereby creating

a flight of funds from US to India. Thus there will be high

supply of US $ in India. As there is more supply than

demand of US $ it will cause appreciation in the

exchange rates of Indian rupees ,i.e., lesser Indian

Rupees will be required to buy the same US $.

When home interest rates are above or are expected to

be above foreign interest rates, the exchange rate will be

appreciated above its purchasing-power-parity level.

When home interest rates are below or are expected to

be below foreign interest rates, the exchange rate will be

depreciated below its purchasing-power-parity level.

http://www.investopedia.com/terms/c/centralbank.asp

http://www.investopedia.com/terms/c/centralbank.asp



We have used rate of returns on 91 day treasury bills as

the representatives for interest rates of that country. The

data is obtained by the rate of returns on the auctions of

these securities by the government of India.

Foreign Exchange Reserves

The level of foreign exchange reserves (including gold)

possessed by the Central Bank or the monetary authority

also has an impact on the current exchange rates.

If the monetary authority feels that its currency is

depreciating in the forex markets (i.e., for the same

amount of Indian rupees you are getting lesser US $) and

has economic reasons to stabilize it. The authority may

step in by selling its foreign exchange out of its stock of

international reserves. Thereby creating a supply of foreign exchange to meet the demand and controlling

the prices of foreign currency.

Thus, if the country has sizeable reserves then it can

contain the depreciation of home currency. But, if the

country does not have sizeable reserves it is helpless and

cannot support its own currency.

It has many other benefits as well:



• support and maintain confidence in the policies formonetary and exchange rate management including thecapacity to intervene in support of the national or union

currency;• limit external vulnerability by maintaining foreign

currency liquidity to absorb shocks during times of crisisor when access to borrowing is curtailed and in doing so;

• provide a level of confidence to markets that a country

can meet its external obligations;

• assist the government in meeting its foreign exchange

needs and external debt obligations;

• provide a level of confidence to markets that a country

can meet its external obligations;

• demonstrate the backing of domestic currency by

external assets;

Foreign Exchange Reserves of India

From Jan-94 to Jan-09

Political stability and economic

performance

Foreign investors inevitably seek out stable countries

with strong economic performance in which to investtheir capital. A country with such positive attributes will



draw investment funds away from other countries

perceived to have more political and economic risk.

Political turmoil, for example, can cause a loss of

confidence in a currency and a movement of capital tothe currencies of more stable countries.

Current-account deficits/Balance of

Payments

The current account is the balance of trade between a

country and its trading partners, reflecting all payments

between countries for goods, services, interest and

dividends. A deficit in the current account shows the

country is spending more on foreign trade than it is

earning, and that it is borrowing capital from foreignsources to make up the deficit.

In other words, the country requires more foreign

currency than it receives through sales of exports, and it

supplies more of its own currency than foreigners

demand for its products. The excess demand for foreign

currency lowers the country's exchange rate. Devaluation

is expected to help in reducing imports (as foreign goodsbecome more costly due to enhanced value of foreign

currency) and in increasing exports (as domestic goods

become cheaper).

So the devaluation goes on until domestic goods and

services are cheap enough for foreigners, and foreign

assets are too expensive to generate sales for domestic

interests. Thus exports will increase and imports will

decrease bringing a balance to the situation.

http://www.investopedia.com/terms/c/currentaccount.asp

http://www.investopedia.com/terms/d/deficit.asp

http://www.investopedia.com/terms/c/currentaccount.asp

http://www.investopedia.com/terms/d/deficit.asp



Another major effect negative balance of payments is

that country will be paying from its forex reserves. We

have already discussed how the depleting forex reserves

affect the country’s economic conditions especiallyexchange rates.

We can see how the structure of balance of payments

impacts the exchange rate of the country and how

positive balance of payments is good for the economy of

the country.

Shocks

Markets don't like unexpected news and because

currency markets are very 'liquid' (shortages of a

currency are very rare), exchange rates are prone tomove quickly in response to surprises. Currencies are

also traded as speculative investments in their own right,

and expert brokers trade them according to how they

think the market will move. But these trades in

themselves will, of course, affect exchange rates.

Index of Industrial Production

Index of Industrial Production (IIP) is one of the Prime

indicators of the economic development for the

measurement of trend in the behavior of the Industrial

Production over a period of time with reference to a

chosen base year. The base year used for calculating IIP

in India is taken as 1993-94. It indicates the relative



change of physical production in the field of industries

during a specified year as compared to previous year.

The index indicates relative change over the time in thevolume of production in non-agricultural commoditiesand it is effective tool to measure the trend of currentIndustrial Production. At the National level, the index of industrial production is being compiled by the CentralStatistical Organization, Govt. of India and is released onmonthly basis.

As the foreign investment is mainly related to industries,higher the IIP better is the performance of the industries,thus higher the return earned by the foreign investors.

Therefore, higher IIP will attract investors to invest in thecountry’s industries. So, it creates demand for the homecurrency (in our model Indian Rupees) and creates supplyof Foreign Currency (US $). This improves the exchangerate of the home currency.

Index of industrial productionFor base year 1993-94 =100

Terms of trade

A ratio comparing export prices to import prices, the

terms of trade is related to current accounts and the

balance of payments. If the price of a country's exports

rises by a greater rate than that of its imports, its terms

of trade have favourably improved. Increasing terms of

trade shows greater demand for the country's exports.

This, in turn, results in rising revenues from exports,

http://www.investopedia.com/terms/b/bop.asp

http://www.investopedia.com/terms/b/bop.asp



which provides increased demand for the country's

currency (and an increase in the currency's value). If the

price of exports rises by a smaller rate than that of its

imports, the currency's value will decrease in relation toits trading partners.

Public debt

Countries engage in large-scale deficit financing to pay

for public sector projects and governmental funding.

While such activity stimulates the domestic economy,

nations with large public deficits and debts are less

attractive to foreign investors. A large debt encourages

inflation, and if inflation is high, the debt will be serviced

and ultimately paid off with cheaper real dollars in the

future.

In the worst case scenario, a government may printmoney to pay part of a large debt, but increasing the

money supply inevitably causes inflation. Moreover, if a

government is not able to service its deficit through

domestic means (selling domestic bonds, increasing the

money supply), then it must increase the supply of

securities for sale to foreigners, thereby lowering their

prices. Finally, a large debt may prove worrisome to

foreigners if they believe the country risks defaulting onits obligations. Foreigners will be less willing to own

securities denominated in that currency if the risk of

default is great. For this reason, the country's debt rating

is a crucial determinant of its exchange rate.

Speculation

http://www.investopedia.com/terms/b/bond.asp

http://www.investopedia.com/terms/d/default2.asp

http://www.investopedia.com/terms/b/bond.asp

http://www.investopedia.com/terms/d/default2.asp



If speculators believe the sterling will rise in the future.

They will demand more now to be able to make a profit.

This increase in demand will cause the value to rise.

Therefore movements in the exchange rate do not alwaysreflect economic fundamentals, but are often driven by

the sentiments of the financial markets.

Gross Domestic Product (GDP) and GDP

growth

The gross domestic product (GDP) is one of the

measures of national income and output for a given

country's economy. It is the total value of all final goods

and services produced in a particular economy; the dollar

value of all goods and services produced within a

country’s borders in a given year. Higher the GDP higher

It is a quantitative representation of the country’s

progress in every sphere of economy. It gives a

mathematical value to the economic health and

economic performance of the country.

High value of GDP and GDP growth, shows well being of

the economy of the country. Foreign investors will be

interested in investing such a country with high GDP

growth as it can give high returns. So, foreign inflow of

cash will bring foreign exchange and so improvement of

exchange rate of home currency.

GDP is the direct estimate of the level of activity in the

country. It indicates the business in the country. So, it is

also a measure of potential of a country of international

trade. Higher levels of economic activity and full

employment have a positive impact on exchange rates.Low level of activity and low level of employment in the

http://en.wikipedia.org/wiki/Country

http://en.wikipedia.org/wiki/Economy

http://en.wikipedia.org/wiki/Country

http://en.wikipedia.org/wiki/Economy



economy increases the probability of depreciation of its

currency. In contrast, growing economies having a higher

level of economic activity and employment have good

potential and prospects of appreciation in the value of their economies.

Institutions tend to move investments out of weakening

economies and into ones perceived to be strengthening.

So an economy whose indicators (like growth, inflation

and debt burden) are positive tends to see more demand

for its currency and see its exchange rate strengthen.

These two graphs show GDP and GDP

growth rate of India

From Jan-94 to Jan-08

CONCLUSIONFrom the regression analysis we can see that the

Exchange rate is significantly predicted by the variables

under observation. We have used linear model for

regression. Goodness of fit, adjusted R square was found

out to be 0.82 which represents a high dependency on

these variables.

The significant variables identified are



1. Interest rate for USA

2. Inflation rate for USA

3. Interest rate for India

4. Inflation rate for India5. Gross Domestic Product, India

6. GDP growth rate, India

7. Foreign Exchange Reserves

8. Index of Industrial Production, IIP

All the variables are significant upto 99% significance

levels except for interest rate for india which is at 90%

significance level which might be due to the uncertainity

in data.

Equation obtained with expected coefficients for

exchange rate is

Exchange rate = - 0.049*(Int. India) - 1.042*(Int.USA)

– 0.241*(Inflation Ind.) +

0.635*(Inflation USA)

+ 0.091*(IIP) - 0.559*(GDP

growth)

- 0.126*(Foreign Ex. Res.) +

253*(GDP in Rs.)

ACKNOWLEDGEMENTS



We would like to sincerely thank Prof. Surendra Singh

Yadav for providing us deep insight into the subject of

managerial accounting and financial management

without which we wouldn’t have been able to take up thisopportunity. Also we humbly thank Alok Dixit sir for

providing us with excellent technical support , and giving

us encouragement for undertaking this topic.

BIBLIOGRAPHY

• Textbook of financial management, M.Y.Khan & P.K.Jain.• Class notes and study material of the course.

• Reserve Bank of India (www.rbi.org.in)

• Ministry of Finance (http://finmin.nic.in)

• Reuters India (http://in.reuters.com)

• www.investopedia.com

• www.wikipedia.org

• Union Budget & Economic

Survey(http://indiabudget.nic.in)• www.economywatch.com/

• Federal Reserve Bank of USA (www.federalreserve.gov/)

• http://www.whitehouse.gov/

• http://indexmundi.com/world/gdp

• http://ezinearticles.com/

• http://hubpages.com/

• http://dipp.nic.in/isu/isu.htm

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Predicting Foreign Exchange Rates