Longer-Term Exchange Rate Anchors
12 Pages Posted: 17 Dec 2018
The goal of this technical note is to give students tools for thinking about how exchange rates will move over a period of five years into the future. While forecasting exchange rates is arguably more art than science, managers, policymakers, and investors are nonetheless often required to form opinions about the future evolution of exchange rates. Specifically, this note defines the real exchange rate and purchasing power parity (PPP) and illustrates that PPP is useful in forecasting nominal exchange rate movements for advanced economies (AEs). For emerging market economies (EMEs), the note explains that PPP is less useful and instead offers a relatively new International Monetary Fund (IMF) model, which evaluates exchange rate over- and undervaluation in EMEs (as well as AEs). The note is designed to be used in a first-year MBA course, specifically in a class structured around exchange-rate forecasts based on recent supplemental data (to be added by the instructor). In that case, the class would build from a question like, “What will the US dollar/British pound exchange rate be in five years, and why?” Note that the IMF material is advanced and, depending on the level of the students and place in the course, may need to be presented as a useful “black box.” In any case, this note could also be employed in an advanced undergraduate or master's level course on international finance or macroeconomics.
Dec. 12, 2018
Longer-Term Exchange-Rate Anchors
Managers of international firms should understand exchange-rate risk and have a sense of whether currencies relevant to their firm are over- or undervalued. If most of your costs are in the domestic currency (e.g., wages) but your revenues are predominantly in a foreign currency (e.g., from exports), then an appreciation of your currency can reduce profits. If you raise your export price, you will lose price-elastic customers. If you don't, an appreciation directly decreases domestic currency revenues relative to costs.
On January 15, 2015, the Swiss National Bank ended its multiyear peg of CHF1.2 per euro. Within a week, the franc appreciated by over 20%, and for the first time ever, one Swiss franc could buy more than one euro. Over the same week, the stock price of Swiss watch manufacturer and exporter Swatch Group fell by over 20% (Figure 1). While hedging such currency risk is possible, doing so may be very costly.
Figure 1. Swatch Group and the Swiss franc.
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Keywords: exchange rates, international finance, exchange-rate prediction, exchange-rate modeling, purchasing power parity, macroeconomics
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