Finally, PPP overlooks the human aspect of exchange rates—the role of people’s confidence and beliefs about a nation’s economy and the value of its currency. Many countries gauge confidence in their economies by conducting a business confidence survey. The largest survey of its kind in Japan is called the tankan survey. It gauges business confidence four times each year among 10,000 companies.
Investor confidence in the value of a currency plays an important role in determining its exchange rate. Suppose several currency traders believe that the Indian rupee will increase in value. They will buy Indian rupees at the current price, sell them if the value increases, and earn a profit. However, suppose that all traders share the same belief and all follow the same course of action. The activity of the traders themselves will be sufficient to push the value of the Indian rupee higher. It does not matter why traders believed the price would increase. As long as enough people act on a similar belief regarding the future value of a currency, its value will change accordingly.
That is why nations try to maintain the confidence of investors, businesspeople, and consumers in their economies. Lost confidence causes companies to put off investing in new products and technologies and to delay the hiring of additional employees. Consumers tend to increase their savings and not increase their debts if they have lost confidence in an economy. These kinds of behaviors act to weaken a nation’s currency.
1. Define the law of one price and explain its limitations.
2. What is purchasing power parity in the context of exchange rates?
3. Briefly explain how both inflation and interest rates influence exchange rates.
4. What are the limitations of purchasing power parity in predicting exchange rates?
Forecasting Exchange Rates
Before undertaking any international business activity, managers should estimate future exchange rates and consider the impact of currency values on earnings. This section explores two distinct views regarding how accurately future exchange rates can be predicted by forward exchange rates—the rate agreed upon for foreign exchange payment at a future date. We also take a brief look at different techniques for forecasting exchange rates.
Efficient Market View
A great deal of debate revolves around the issue of whether markets themselves are efficient or inefficient in forecasting exchange rates. A market is efficient if prices of financial instruments quickly reflect new public information made available to traders. The efficient market view thus holds that prices of financial instruments reflect all publicly available information at any given time. As applied to exchange rates, this means that forward exchange rates are accurate forecasts of future exchange rates.
efficient market view
View that prices of financial instruments reflect all publicly available information at any given time.
Recall from Chapter 9 that a forward exchange rate reflects a market’s expectations about the future values of two currencies. In an efficient currency market, forward exchange rates reflect all relevant publicly available information at any given time; they are considered the best possible predictors of exchange rates. Proponents of this view hold that there is no other publicly available information that could improve the forecast of exchange rates over that provided by forward rates. To accept this view is to accept that companies do waste time and money collecting and examining information believed to affect future exchange rates. But there is always a certain amount of deviation between forward and actual exchange rates. The fact that forward exchange rates are less than perfect inspires companies to search for more accurate forecasting techniques.
Inefficient Market View
The inefficient market view holds that prices of financial instruments do not reflect all publicly available information. Proponents of this view believe companies can search for new pieces of information to improve forecasting. But the cost of searching for further information must not outweigh the benefits of its discovery.
inefficient market view
View that prices of financial instruments do not reflect all publicly available information.
Naturally, the inefficient market view is more compelling when the existence of private information is considered. Suppose a single currency trader holds privileged information regarding a future change in a nation’s economic policy—information that she believes will affect its exchange rate. Because the market is unaware of this information, it is not reflected in forward exchange rates. Our trader will no doubt earn a profit by acting on her store of private information.
Now that we understand the two basic views related to market efficiency, let’s look at the specific methods that companies use to forecast exchange rates.
The issue of whether markets are efficient or inefficient forecasters of exchange rates leads to the question of whether experts can improve on the forecasts of forward exchange rates in either an efficient or inefficient market. As we have already seen, some analysts believe that forecasts of exchange rates can be improved by uncovering information not reflected in forward exchange rates. In fact, companies exist to provide exactly this type of service. There are two main forecasting techniques based on this belief in the value of added information—fundamental analysis and technical analysis.