Currency Exchange Rates: Understanding Equilibrium Value

Exchange rates are among the most difficult financial market prices to understand and therefore to value. There is no simple, robust framework that investors can rely on in assessing the appropriate level and likely movements of exchange rates.

Most economists believe that there is an equilibrium level or a path to that equilibrium value that a currency will gravitate toward in the long run. Although short- and medium-term cyclical deviations from the long-run equilibrium path can be sizable and persistent, fundamental forces should eventually drive the currency back toward its long-run equilibrium path. Evidence suggests that misalignments tend to build up gradually over time. As these misalignments build, they are likely to generate serious economic imbalances that will eventually lead to correction of the underlying exchange rate misalignment.

We have described how changes in monetary policy, fiscal policy, current account trends, and capital flows affect exchange rate trends, as well as what role government intervention and capital controls can play in counteracting potentially undesirable exchange rate movements. We have made the following key points:

• Spot exchange rates apply to trades for the next settlement date (usually T + 2) for a given currency pair. Forward exchange rates apply to trades to be settled at any longer maturity.

• Market makers quote bid and offer prices (in terms of the price currency) at which they will buy or sell the base currency.

  • The offer price is always higher than the bid price.

  • The counterparty that asks for a two-sided price quote has the option (but not the obligation) to deal at either the bid or offer price quoted.

  • The bid–offer spread depends on (1) the currency pair involved, (2) the time of day, (3) market volatility, (4) the transaction size, and (5) the relationship between the dealer and the client. Spreads are tightest in highly liquid currency pairs, when the key market centers are open, and when market volatility is relatively low.

• Absence of arbitrage requires the following:

  • The bid (offer) shown by a dealer in the interbank market cannot be higher (lower) than the current interbank offer (bid) price.

  • The cross-rate bids (offers) posted by a dealer must be lower (higher) than the implied cross-rate offers (bids) available in the interbank market. If they are not, then a triangular arbitrage opportunity arises.

• Forward exchange rates are quoted in terms of points to be added to the spot exchange rate. If the points are positive (negative), the base currency is trading at a forward premium (discount). The points are proportional to the interest rate differential and approximately proportional to the time to maturity.

• International parity conditions show us how expected inflation, interest rate differentials, forward exchange rates, and expected future spot exchange rates are linked. In an ideal world,

  • relative expected inflation rates should determine relative nominal interest rates,

  • relative interest rates should determine forward exchange rates, and

  • forward exchange rates should correctly anticipate the path of the future spot exchange rate.

• International parity conditions tell us that countries with high (low) expected inflation rates should see their currencies depreciate (appreciate) over time, that high-yield currencies should depreciate relative to low-yield currencies over time, and that forward exchange rates should function as unbiased predictors of future spot exchange rates.

• With the exception of covered interest rate parity, which is enforced by arbitrage, the key international parity conditions rarely hold in either the short or medium term. However, the parity conditions tend to hold over relatively long horizons.

• According to the theory of covered interest rate parity, a foreign-currency-denominated money market investment that is completely hedged against exchange rate risk in the forward market should yield exactly the same return as an otherwise identical domestic money market investment.

• According to the theory of uncovered interest rate parity, the expected change in a domestic currency’s value should be fully reflected in domestic–foreign interest rate spreads. Hence, an unhedged foreign-currency-denominated money market investment is expected to yield the same return as an otherwise identical domestic money market investment.

• According to the ex ante purchasing power parity condition, expected changes in exchange rates should equal the difference in expected national inflation rates.

• If both ex ante purchasing power parity and uncovered interest rate parity held, real interest rates across all markets would be the same. This result is real interest rate parity.

• The international Fisher effect says that the nominal interest rate differential between two currencies equals the difference between the expected inflation rates. The international Fisher effect assumes that risk premiums are the same throughout the world.

• If both covered and uncovered interest rate parity held, then forward rate parity would hold and the market would set the forward exchange rate equal to the expected spot exchange rate: The forward exchange rate would serve as an unbiased predictor of the future spot exchange rate.

• Most studies have found that high-yield currencies do not depreciate and low-yield currencies do not appreciate as much as yield spreads would suggest over short to medium periods, thus violating the theory of uncovered interest rate parity.

• Carry trades overweight high-yield currencies at the expense of low-yield currencies. Historically, carry trades have generated attractive returns in benign market conditions but tend to perform poorly (i.e., are subject to crash risk) when market conditions are highly volatile.

• According to a balance of payments approach, countries that run persistent current account deficits will generally see their currencies weaken over time. Similarly, countries that run persistent current account surpluses will tend to see their currencies appreciate over time.

• Large current account imbalances can persist for long periods of time before they trigger an adjustment in exchange rates.

• Greater financial integration of the world’s capital markets and greater freedom of capital to flow across national borders have increased the importance of global capital flows in determining exchange rates.

• Countries that institute relatively tight monetary policies, introduce structural economic reforms, and lower budget deficits will often see their currencies strengthen over time as capital flows respond positively to relatively high nominal interest rates, lower inflation expectations, a lower risk premium, and an upward revision in the market’s assessment of what exchange rate level constitutes long-run fair value.

• Monetary policy affects the exchange rate through a variety of channels. In the Mundell–Fleming model, it does so primarily through the interest rate sensitivity of capital flows, strengthening the currency when monetary policy is tightened and weakening it when monetary policy is eased. The more sensitive capital flows are to the change in interest rates, the greater the exchange rate’s responsiveness to the change in monetary policy.

• In the monetary model of exchange rate determination, monetary policy is deemed to have a direct impact on the actual and expected path of inflation, which, via purchasing power parity, translates into a corresponding impact on the exchange rate.

• Countries that pursue overly easy monetary policies will see their currencies depreciate over time.

• In the Mundell–Fleming model, an expansionary fiscal policy typically results in a rise in domestic interest rates and an increase in economic activity. The rise in domestic interest rates should induce a capital inflow, which is positive for the domestic currency, but the rise in economic activity should contribute to a deterioration of the trade balance, which is negative for the domestic currency. The more mobile capital flows are, the greater the likelihood that the induced inflow of capital will dominate the deterioration in trade.

• Under conditions of high capital mobility, countries that simultaneously pursue expansionary fiscal policies and relatively tight monetary policies should see their currencies strengthen over time.

• The portfolio balance model of exchange rate determination asserts that increases in government debt resulting from a rising budget deficit will be willingly held by investors only if they are compensated in the form of a higher expected return. The higher expected return could come from (1) higher interest rates and/or a higher risk premium, (2) depreciation of the currency to a level sufficient to generate anticipation of gains from subsequent currency appreciation, or (3) some combination of the two.

• Surges in capital inflows can fuel boom-like conditions, asset price bubbles, and currency overvaluation.

• Many consider capital controls to be a legitimate part of a policymaker’s toolkit. The IMF believes that capital controls may be needed to prevent exchange rates from overshooting, asset price bubbles from forming, and future financial conditions from deteriorating.

• The evidence indicates that government policies have had a significant impact on the course of exchange rates. Relative to developed countries, emerging markets may have greater success in managing their exchange rates because of their large foreign exchange reserve holdings, which appear sizable relative to the limited turnover of FX transactions in many emerging markets.

• Although each currency crisis is distinct in some respects, the following factors were identified in one or more studies:

  1. Prior to a currency crisis, the capital markets have been liberalized to allow the free flow of capital.

  2. There are large inflows of foreign capital (relative to GDP) in the period leading up to a crisis, with short-term funding denominated in a foreign currency being particularly problematic.

  3. Currency crises are often preceded by (and often coincide with) banking crises.

  4. Countries with fixed or partially fixed exchange rates are more susceptible to currency crises than countries with floating exchange rates.

  5. Foreign exchange reserves tend to decline precipitously as a crisis approaches.

  6. In the period leading up to a crisis, the currency has risen substantially relative to its historical mean.

  7. The terms of trade (exports relative to imports) often deteriorate before a crisis.

  8. Broad money growth and the ratio of M2 (a measure of money supply) to bank reserves tend to rise prior to a crisis.

  9. Inflation tends to be significantly higher in pre-crisis periods compared with tranquil periods.