Currency exchange rates are determined by the supply
and demand for the currencies. For some countries, the foreign exchange rate is
the single most important parameter in the economy since; it determines the
international balance of payments. There is no general rule to determine
foreign exchange rate, but Eiteman has suggested the potential exchange rate
determinants into five areas
·
Parity conditions
·
Infrastructure
·
Speculation
·
Cross-border FDI and Portfolio Investments
·
Political risks
Even though there is no model which has been consistent in predicting
short-term foreign exchange rates, but there are several major concepts that
can be used to determine the long-term behavior of foreign exchange rates.
Purchasing Power Parity
Purchasing power parity (PPP) states that over the long-run the
exchange rate between two currencies adjusts to relative price levels. Over longer time periods, PPP does tend to
hold, in part since countries take this approach seriously and act to control
relative inflation rates. For the short term period, however, other factors
such as capital flows can remove the impact of PPP.
Balance of Payments
Balance of payments (BOP) was
the initial approach used for economic modeling of the exchange rates. BOP concept
traces all of the financial flows in the country during the given time horizon.
All the financial transactions that occur are treated as credit and the final
balance must be zero. BOP is equal to Current account plus Capital account Plus
official reserve account which must be zero.
The Current account contains
the trade balance, net income received, balance of services and unrequited
transfers. The capital account includes the FDI, Portfolio investment, other
capital inflows and net errors and omissions. Official reserve account includes
the net changes in the country’s international reserves.
Relative Economic
Strength
This approach focuses on the investment flows rather than the trade
flows. The rationale behind this concept is that strong economies are likely to
attract more capital, which causes the currencies to increase. Foreign
investors must always weigh whether the higher yield offsets the risk of
inflated currency values. Relative Economic Strength demonstrates how
currencies should respond to economic news, but does not imply a “true”
currency value. Because of this, many investors combine Purchasing power parity
and Relative Economic strength for a more complete theory of interest rate
movements.
Asset
Approach
The asset
approach is based on the ideas that markets are efficient and that exchange
rates are assets traded in an efficient market.
The asset approach predicts that the spot rate behaves like any other
asset--the value of the spot rate changes whenever relevant information is
released. Therefore, prices are
determined based on expectations about the future. This approach focuses on the relationship
between the capital account and exchange rates.