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VWL (Subject) / Determination of Development of Exchange Rate Risk (Lesson)

VWL Theorie Part 3 (2)

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  • Which two major approaches/general guidelines exist for the prediction of the price of an asset/an exchange rate? 1) Hypothesis of efficient markets 2) Hypothesis of behavioral finance (Assumption: The price of a foreign currncy can be regarded as the price of an asset)
  • What does the hypothesis of efficient markets say? Market prices are reflecting all known information and behave rationally according to this information.
  • What does the hypothesis of behavioral finance say? -Psychology of market participants --> Very important factor to explain changes in asset prices -No rational homo oeconomicus (looks only at the facts), but psychology of the market players can lead to irrational behaviour --> approach supported by the fact that extreme events like panics/bubbles occur much more frequently than anticipated -Here: More important to predict psychology & mood of market participants (not only facts) -The better you can predict the behaviour of the participants, the better you can predict the development of exchange rates
  • Which two main approaches are offered by economic theory to explain the changes of the exchange rate? Which sub-theories do exist? 1. Theory of Purchasing Power Parity a) Law of One Price b) Theory of Absolute Purchasing Power Parity c) Theory of Relative Purchasing Power Parity 2. Theory of Interest Parity
  • What does the Law of One Price say? -Identical goods, sold in different markets should be traded at the same price (after conversion) -Exchange rate should change in that way, that one product costs the same in two countries, otherwise there would be an arbitrage opportunity.
  • Which Index has been developed with the approach of the Law of One Price? What is the critique to it? --> Approach is used by the Economist magazine to determine Bic-Mac-Index BUT: Would explain change in exchange rate by the change of the price of only one good -->Therefore: More elaborate approach has been developed
  • What does the Theory of Absolute Purchasing Power Parity say? The exchange rate of two countries can be explained by the ratio of their currencies. --> Take the price level (cost of basket) to determine exchange rate.
  • What does the Theory of Relative Purchasing Power Parity say? -Exchange rate will change, when a change of the price level in the respective partner countries happens. -Theory does not explain the exchange rate by the price levels of two countries --> only states that changes in the exchange rate will take place, if there are differences in the inflation rate between two countries.
  • What are the assumptions for the Theory of Purchasing Power Parity? 1) In the foreign exchange market there are only trade related transactions. 2) There are no transport costs 3) There are no trade barriers 4) There are no non-tradable goods 5) There are competitive markets, i.e. no monopolistc or oligopolistic practices. 6) There are no differences in inflation measurement 7) There are no interventions of central banks
  • What does the theory of interest parity say? The difference between the spot rate and the forward rate of a currency exchange rate can be explained by the interest rate differentials between two countries.
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  • What are the assumptions of the Theory of Interest Parity? -Foreign exchange market will ensure that deposits of all currencies offer the same rate of return in different countries. -Most important assumption --> Foreign exchange market is determined only by interest rate related transactions (buying and selling of bonds)
  • Which exchange rate concepts exist? 1. Nominal Exchange Rate 2. Real Exchange Rate 3. Effective Exchange Rate 4. Real Effective Exchange Rate
  • Explain the nominal exchange rate. Indicates the number of units of domestic currency that can buy one unit of foreign currency (price quotation)
  • Explain the real exchange rate. Nominal exchange rate adjusted for price changes in the two currencies. ER real = ER nom x (CPI Home/CPI Foreign Country)
  • Explain the effective exchange rate. Calculated by adding the unadjusted weighted average of the ER of the major trade parners to obtain changes of the national ER vis-á-vis its major trade partners
  • Explain the real effective exchange rate. Measures nominal changes of the ER of the major trade partners and adjusts changes by the differences in inflation rates of these partners.

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