Economics and Finance Term Paper

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Exchange Rate Volatility and International Trade

The foreign exchange rate market offers investors a chance to make a considerably larger return on their investment than any other market in the world. However, along with these potential gains comes a considerable risk as well. Foreign exchange rates are extremely volatile and dependent on many variables. Understanding the factors that influence foreign exchange rates can mean the difference between profit and loss for an investor.

Financial markets are experiencing a greater amount of integration than ever before. This is mainly due to advances in communications, such as the Internet, that allow for the ready exchange of business across borders that was not possible in the past. This movement towards a "global economy" will be certain to have an impact on the foreign exchange markets. International markets used to be the realm of large corporations, but now this is not always true. The Internet has allows small and medium businesses to compete on this level as well. Foreign exchange rates are becoming an important issue for many people who were previously not concerned because it did not directly effect their lives. Now it is important for everyone to have an understanding of what drives foreign exchange rates.

The foreign exchange market is the only market that is open 24 hours a day. The day begins in Japan, then moves to Hong Kong and then to London and the United States. It is difficult to maintain order in such an environment and the central banks sometimes intervene through trading to make sure that global chaos does not erupt. This trading usually takes place using the U.S. dollar. This is partially because the U.S. dollar has lower transaction costs than other currency. A British exporter wishing to purchase Japanese yen would pay a transaction fee to the broker for the transaction. This ultimately drives up the price of the export transaction, or possible makes it less profitable and may serve to limit foreign trade activities. As smaller businesses enter into this market, the volatility caused by these transactions has a larger impact on an individual economy and the global market as a whole. Small businesses may not be able to survive the volatility as well as larger businesses that often have options not available to small businesses to protect themselves from the downside risk of this volatility.

Many economic theorists have constructed models to help predict this volatility. The following research will explain some of these models including the Purchasing Power Parity Model, Monetary Model, and the Portfolio Balance model. These are not the only models; however, they are the most widely accepted among those who play the foreign exchange markets. These models are not perfect and these imperfections will be the subject of further discussion. There have been many academic studies conducted around these theories. The following research will examine some of this work and discuss its impact. It is hoped that this research will help give a well-rounded understanding of how the foreign exchange rate market operate and its effects on foreign trade volumes.

Purchasing Power Parity (PPP)

The real question is how to predict volatility trends and be able to adjust sales and exports in relation to the predicted exchange rates. There are many models that propose to do just that. One of the first models for attempting to predict volatility trends was the Purchasing Power Parity

PPP) model. This model assumes that the exchange rate between two currencies would be equal to the relevant national price levels of those countries. This would result in a common currency rate and the common currency would have the same purchasing power per unit of goods in each country. This is a nice theory, if the economies of the two countries are similar and have similar inflation rates, GDP and other similarities, but this is usually not the case.

The PPP is often discussed in terms of absolute PPP and relative PPP. Relative PPP occurs when the rate of depreciation of one currency relative to another matches the difference in aggregate price inflation between the two countries (Sarno and Taylor, 2002). The real exchange rate is adjusted for relative national price differences between the two countries. If the PPP model is true, then the real exchange rate is constant. This would mean that fluctuations in the real exchange rate would represent a deviation from the PPP. This means that the two are directly related and that the PPP is directly related to the real exchange rate (Sarno and Taylor, 2002).

It has been difficult to prove this model in the long run. It is difficult to prove empirically, although many valiant attempts have been made using different time periods of data. These results are widely mixed One of the most widely accepted and cited studies was conducted by Diebold, Husted and Rush (1991). It supports the ability of the PPP model to predict long-term volatility in foreign exchange markets. These researchers cleared many of the problems associated with previous research by eliminating the unit root for a large sample of exchange rates. This had been a confounding variable in many of the previous tests, especially those that dealt with small sample sizes.

Diebold, Husted and Rush developed a model that worked in the long-term. However, this example is set against many others before them who had failed to produce long-term predictive results.

This work seems to work as long as we are comparing apples to apples, that is industrialized nations to industrialized nations. These previous studies, not only fail to predict long-term results, but do not take into account shocks to the market and their effects on volatility. They seem to have forgot that it is volatility that we wished to measure in the first place and shocks cause volatility, therefore the negligence to account for shocks to the market, make the test results only valid in theory and they do not work in the real world.

There are many problems associated with assumption in the PPP model. One of the key assumptions is that the same weights are applied to each country. Price index weights will not be equal for all countries. Furthermore these weights change over time. Not every country produces the same goods n and services and therefore cannot be equally paired with another country that produces different goods and services. Some goods and services may be absent altogether from one country. These balances shift over time and the PPP model fails to account for these shifts.

Summers and Heston (1991) solved this delimma by borrowing a technique from estimating the Gross Domestic Product (GDP) of a country. In order to make a fair comparison of the production levels of unequal countries, economists construct a variable using a common basket of goods for each country. That is each country is evaluated on the same goods as every other country regardless of any other product that they may produce. It is an attempt to compare apples to apples. Summer and Heston call their model the International Comparison Programme (ICP) data set.

This would seem like a reasonable solution to the problem of how to compare unequal countries, however, they made several errors in the development of their model that make it impractical to estimate PPP. They used random, large time intervals and these are not necessarily the same time intervals used in PPP equations. The data would be comparing two different economic time periods and therefore is not a valid solution to the problem. For this reason, the price indices from official sources are still the basis for PPP calculations, even though they may not be entirely flawless either.

The modern version of PPP developed in stages. First, there was the original version of the equation in and all of its faults. Then there were the random walk hypothesis, cointegration studies, and long-term studies, panel data studies and finally studies that did not use linear econometric techniques. Absolute PPP draws a correlation between the ratio of two national price levels and the nominal exchange rate. If this were true then changes that effect one would automatically effect the other in the same amount. There are many effects that this would over look. The first thing that is overlooked is that short-term and long-term effects may be different.

PPP was originally supposed to be applied only to long-term analysis. Some early criticisms of the theory indicate that the theory is not supported and does not hold true when applied to short-term analysis. They therefore rejected the theory altogether. Frenkel (1978) applied PPP to long-term data and found it to produce a close unity on long-term data for high inflation countries. This would seem to confirm the posits of the developers of PPP. However, there are several things that Frenkel neglected to account for which tend once again rally support for the rejection of the PPP model. Frenkel neglected to test the stochastic properties of the residuals to determine if they are stationary. This could…[continue]

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