WHEN THE DOLLAR WAS KING (1999–2001)
WHEN THE DOLLAR WAS KING (1999–2001)
Determining why foreign exchange rates move the way they do may Dseem a far too ambitious and challenging task, as it requires making sense of an unlimited array of factors ranging from fundamentals (macroeconomic changes, central bank actions, capital markets changes, corporate/dealer transactions, political and geopolitical factors, and news reports) to technicals (price charts, momentum, oscillators, moving aver-ages) to pure flow-driven developments. Other books tackle the theories of international economics and finance that explain the principle drivers of foreign exchange rates. Since this book aims at focusing on the real-world developments impacting currencies, textbook theories take a secondary role in shedding light on the major developments in currencies. These the-ories are only briefly mentioned. Chapter 3 and 4 tackle the trends in major foreign exchange rates between 1999 and 2007, identifying the highest- and lowest-performing currencies, and citing the fundamental reasons for these developments.
This analysis calculates the annual changes in the values of curren-cies against one another to determine a ranking of currency returns. Per-formances are examined against a host of fundamental variables such as national GDP growth, world and regional GDP growth, interest rates and central bank action, capital flows, current account balances, and export dy-namics such as commodities markets. The real-world developments that dictate the major trends in global currencies demonstrate the theories and paradigms that worked, and the reasons for their prevalence during those years.
THE MAJOR THEORIES
As mentioned earlier, we will give a brief account of the major theories of international economics seeking to explain foreign exchange market val-ues, before tackling the practical underpinnings behind the performance of each of the nine major currencies. This way, those not familiar with the theories will be able to reconcile and relate the real-life dynamics of foreign exchange movements to the theoretical properties, wherever possible.
PURCHASING POWER PARITY
The theory of purchasing power parity (PPP) states that exchange rates are determined by deriving relative prices of similar baskets of goods across different currencies. Changes in inflation rates are expected to be offset by equal but opposite changes in the exchange rate.
The major advantage of PPP is that it provides for convenient and easy comparisons when using similar products. However, the theory is valid only for goods that are easily tradable, with no transaction costs taken into consideration, such as tariffs, quotas, and taxes. In fact, PPP is only valid for goods, not for services or in cases of significant differences in val-ues. One clear disadvantage of PPP is its disregard for market dynamics such as economic releases, asset markets, sentiment, and the role of po-litical and geopolitical factors. There was little empirical evidence of the effectiveness of PPP prior to the 1990s. Thereafter, PPP was seen to have worked only in the long term (three to five years) when prices eventually correct toward parity.
INTEREST RATE PARITY
The theory of interest rate parity (IRP) holds that a currency’s appre-ciation (depreciation) versus another currency in the future must be neutralized by the interest rate differential. If Eurozone interest rates exceed their U.S. counterpart, then the euro should depreciate against the U.S. dollar by the percentage that prevents riskless arbitrage. That depreciation (appreciation) is reflected into the forward exchange rate stated today.
Interest rate parity theory is the underlining foundation of pricing cur-rency forward and futures contracts. Its main weakness is the lack of proof after the 1990s. Contrary to the theory, currencies with higher interest rates characteristically appreciated rather than depreciated on the reward of fu-ture containment of inflation and a higher-yielding currency.
BALANCE OF PAYMENTS MODEL
The balance of payments model (BOP) maintains that a nation’s currency must be at the rate that produces a stable current account balance. This rate is known as the rate of equilibrium. A nation with a trade deficit expe-riences erosion in its foreign exchange reserves, and a subsequent decline in its value. As the currency becomes cheaper, it renders exports more af-fordable and imports more expensive, thus reducing the trade imbalance.
PLEASE READ ALSO : ANNUAL PERFORMANCE ANALYSIS OF INDIVIDUAL CURRENCIES AND 1999: RISK AVERSION, BOTTOM FISHING BOOSTS JAPANESE STOCKS AND THE YEN
As in the case of purchasing power parity, the balance of payments model addresses mainly tradable goods and services, while ignoring the increasing role of global capital flows. As investors purchase other nations’ stocks and bonds, their flows are added to the capital account (also known as the financial account) item in the balance of payments, thus balancing the deficit in the current account. The increase in capital flows has given rise to the asset market model.
ASSET MARKET MODEL
The asset market model (AMM) addresses cross-border portfolio flows (purchases/sales of stocks and bonds) in evaluating currency values. The emergence of cross-border capital flows and trading of financial assets has reshaped the way markets approach currencies. Only 1 percent of all for-eign exchange (FX) transactions are trade-related.
Economic variables such as growth, inflation, and productivity are no longer the only drivers of currency movements. The proportion of FX trans-actions stemming from cross-border trading of financial assets has dwarfed transactions in goods and services by several hundred times.
Determining why foreign exchange rates move the way they do may Dseem a far too ambitious and challenging task, as it requires making sense of an unlimited array of factors ranging from fundamentals (macroeconomic changes, central bank actions, capital markets changes, corporate/dealer transactions, political and geopolitical factors, and news reports) to technicals (price charts, momentum, oscillators, moving aver-ages) to pure flow-driven developments. Other books tackle the theories of international economics and finance that explain the principle drivers of foreign exchange rates. Since this book aims at focusing on the real-world developments impacting currencies, textbook theories take a secondary role in shedding light on the major developments in currencies. These the-ories are only briefly mentioned. Chapter 3 and 4 tackle the trends in major foreign exchange rates between 1999 and 2007, identifying the highest- and lowest-performing currencies, and citing the fundamental reasons for these developments.
This analysis calculates the annual changes in the values of curren-cies against one another to determine a ranking of currency returns. Per-formances are examined against a host of fundamental variables such as national GDP growth, world and regional GDP growth, interest rates and central bank action, capital flows, current account balances, and export dy-namics such as commodities markets. The real-world developments that dictate the major trends in global currencies demonstrate the theories and paradigms that worked, and the reasons for their prevalence during those years.
THE MAJOR THEORIES
As mentioned earlier, we will give a brief account of the major theories of international economics seeking to explain foreign exchange market val-ues, before tackling the practical underpinnings behind the performance of each of the nine major currencies. This way, those not familiar with the theories will be able to reconcile and relate the real-life dynamics of foreign exchange movements to the theoretical properties, wherever possible.
PURCHASING POWER PARITY
The theory of purchasing power parity (PPP) states that exchange rates are determined by deriving relative prices of similar baskets of goods across different currencies. Changes in inflation rates are expected to be offset by equal but opposite changes in the exchange rate.
The major advantage of PPP is that it provides for convenient and easy comparisons when using similar products. However, the theory is valid only for goods that are easily tradable, with no transaction costs taken into consideration, such as tariffs, quotas, and taxes. In fact, PPP is only valid for goods, not for services or in cases of significant differences in val-ues. One clear disadvantage of PPP is its disregard for market dynamics such as economic releases, asset markets, sentiment, and the role of po-litical and geopolitical factors. There was little empirical evidence of the effectiveness of PPP prior to the 1990s. Thereafter, PPP was seen to have worked only in the long term (three to five years) when prices eventually correct toward parity.
INTEREST RATE PARITY
The theory of interest rate parity (IRP) holds that a currency’s appre-ciation (depreciation) versus another currency in the future must be neutralized by the interest rate differential. If Eurozone interest rates exceed their U.S. counterpart, then the euro should depreciate against the U.S. dollar by the percentage that prevents riskless arbitrage. That depreciation (appreciation) is reflected into the forward exchange rate stated today.
Interest rate parity theory is the underlining foundation of pricing cur-rency forward and futures contracts. Its main weakness is the lack of proof after the 1990s. Contrary to the theory, currencies with higher interest rates characteristically appreciated rather than depreciated on the reward of fu-ture containment of inflation and a higher-yielding currency.
BALANCE OF PAYMENTS MODEL
The balance of payments model (BOP) maintains that a nation’s currency must be at the rate that produces a stable current account balance. This rate is known as the rate of equilibrium. A nation with a trade deficit expe-riences erosion in its foreign exchange reserves, and a subsequent decline in its value. As the currency becomes cheaper, it renders exports more af-fordable and imports more expensive, thus reducing the trade imbalance.
PLEASE READ ALSO : ANNUAL PERFORMANCE ANALYSIS OF INDIVIDUAL CURRENCIES AND 1999: RISK AVERSION, BOTTOM FISHING BOOSTS JAPANESE STOCKS AND THE YEN
As in the case of purchasing power parity, the balance of payments model addresses mainly tradable goods and services, while ignoring the increasing role of global capital flows. As investors purchase other nations’ stocks and bonds, their flows are added to the capital account (also known as the financial account) item in the balance of payments, thus balancing the deficit in the current account. The increase in capital flows has given rise to the asset market model.
ASSET MARKET MODEL
The asset market model (AMM) addresses cross-border portfolio flows (purchases/sales of stocks and bonds) in evaluating currency values. The emergence of cross-border capital flows and trading of financial assets has reshaped the way markets approach currencies. Only 1 percent of all for-eign exchange (FX) transactions are trade-related.
Economic variables such as growth, inflation, and productivity are no longer the only drivers of currency movements. The proportion of FX trans-actions stemming from cross-border trading of financial assets has dwarfed transactions in goods and services by several hundred times.
0 Response to "WHEN THE DOLLAR WAS KING (1999–2001)"
Post a Comment