Question

Topic 1. Fundamental Analysis

We studied that there are three ways to forecast exchange rates. In this thread, I would like to discuss fundamental analysis. Some issues to consider: What types of determinants do you think are important in terms of exchange rates? Where could we get measures of those determinants in practice? Are there macroeconomic variables that are more important than others for the determination of exchange rates? Do you think it is harder/easier to forecast fixed or flexible exchange rates and what would you do differently to forecast one or the other?

Answer 1

Fundamental analysis is the study of economic factors that influence foreign exchange rates in the hope of trying to forecast future rates. ... The most important economic factors of the 2 currencies being compared are inflation rates, interest rates, and investment opportunities.

Main Factors that Influence Exchange Rates:

1. Inflation Rates:

Typically, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. During the last half of the 20th century, the countries with low inflation included Japan, Germany and Switzerland, while the U.S. and Canada achieved low inflation only later. Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates.

2. Interest Rates:

Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates – that is, lower interest rates tend to decrease exchange rates.

3. Current Account Deficits:

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 foreign sources 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 until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests.

4. Public Debt:

Countries will 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. The reason? 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 print money 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 on its 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 (as determined by Moody's or Standard & Poor's, for example) is a crucial determinant of its exchange rate.

5. 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 favorably improved. Increasing terms of trade shows greater demand for the country's exports. This, in turn, results in rising revenues from exports, 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 to its trading partners.

6. Political Stability and Economic Performance:

Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their 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 to the currencies of more stable countries.

7. Recession:

When a country experiences a recession, its interest rates are likely to fall, decreasing its chances to acquire foreign capital. As a result, its currency weakens in comparison to that of other countries, therefore lowering the exchange rate.

8. Speculation

If a country's currency value is expected to rise, investors will demand more of that currency in order to make a profit in the near future. As a result, the value of the currency will rise due to the increase in demand. With this increase in currency value comes a rise in the exchange rate as well.

Exchange rate fluctuation is defined as the risk associated with unpredicted movements in exchange rate. Macroeconomic variables such as interest rate, inflation rate, the balance of payments, tax rate etc influence the exchange rares randomly. Exchange rate is not an exception as it is closely aligned to macroeconomic variables.

Fixed and Flexible exchange rates:

The exchange rates may be fixed or flexible. Different methods are used to forecast fixed and flexible exchange rates. The flexible exchange rates are determined by the market focus of demand and supply. These are not influenced by government intervention. Fixed exchange rates, on the other hand, are decided by the regulating agencies.

Methods of forecasting exchange rates:

The flexible exchange rates may be forecasted with the help of various methods. Fundamental and technical analysis are commonly used for this purpose.

1. Fundamental analysis method: It studies the relationship between macro economic variables (such as inflation rates, national income growth, and changes in money supply) and exchange rates to forecast the latter. Technical analysis uses past prices and volume movements to project future currency exchange rates.

2. Technical Analysis method: The technical analysis may produce useful results if the past trend is repeated. The companies normally use technical analysis for short-term forecasts. but, they use fundamental analysis for long-term projections.

Forecasting of fixed exchange rates:

Fixed exchange rate forecasts are based on the study of government decision-making structure. Attempts are made to determine the pressure to devalue the currency of the nation and the ability of the government to sustain the disequilibrium.

Forecasting fixed exchange rates requires an assessment of balance-of-payments disequilibrium on the basis of key economic variables such as inflation, money supply, international reserves, gap between official and market rates, and the balance of foreign trade.

The change in the exchange rate required to restore the balance of payment equilibrium is estimated with the help of forward exchange rates, free market rates and the purchasing power parity principle. The capacity of the country to resist or postpone the use of corrective measures is evaluated on the basis of the ability to borrow hard currencies and the availability of international reserves. Attempt is also made to project the policies which may be followed by the Government to correct the position of the nation.

Thus, exchange rates are forecasted to make various decisions by the companies which require foreign exchange. These forecasts are made separately for the fixed and floating exchange rates with the help of different methods. Percentage change between forecasted and current exchange rates may be calculated to find out appreciation or depreciation in the currency