# Exchange Rate Determination

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exchange rate determination

“Having endeavored to forecast exchange rates for more than half a century, I have understandably developed significant humility about my ability in this area…”[1] - Alan Greenspan

Figure 1: Exchange Rate Determination
[pic]
Source: Exchange Rate Determination

I. Short-Run Forecasting Tools

Short-term changes in exchange rates are the most difficult to predict and are often determined based on bandwagon effects, overreaction to news, speculation, and technical analysis.[2]

Trend-Following Behavior is the tendency for the market to follow a trend. In other words an increase in the exchange rate is more likely to be followed by another increase.

Investor Sentiment is based on the
Figure 2: International Parity Conditions
[pic]
Source: Exchange Rate Determination

1) Purchasing power parity – states that since the prices should be the same across countries, the exchange rate between two countries should be the ratio of the prices in each country.

[pic]

Example: If a hamburger is \$2.54 in the United States and 3.60 real (R\$) in Brazil, then the PPP spot rate should be:

[pic] If the actual exchange rate is[pic], then according to the PPP theory the Brazilian real is undervalued by 35%. [pic] FYI McDonalds' Big Mac is produced locally in almost 120 countries![7]

2) Covered interest-rate parity –the idea that an imbalance in parity conditions can create a “risk less” opportunity for an arbitrager.

Exhibit 6.7 Covered Interest Arbitrage (CIA)[8] [pic]

Example: Step 1: Convert \$1,000,000 at the spot rate of ¥106.00/\$ to ¥106,000,000 Step 2: Invest the proceeds, (¥106,000,000), in a euroyen account for six months, earning 4% per annum, or 2% for 180 days. Step 3: Simultaneously sell the future yen proceeds (¥108,120,000) forward for dollars at the 180-day forward rate of ¥103.50/\$. Note: at this point you have