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Exchange Rate Determination: The Theoretical Thread The monetary approach in its simplest form states that the exchange rate is determined by the supply and demand for national monetary stocks, as well as the expected future levels and rates of growth of monetary stocks. Other financial assets, such as bonds are not considered relevant for exchange rate determination, as both domestic and foreign bonds are viewed as perfect substitutes.
Copyright 2010 Pearson Prentice Hall. All rights reserved.
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Exchange Rate Determination: The Theoretical Thread The asset market approach argues that exchange rates are determined by the supply and demand for a wide variety of financial assets:
Shifts in the supply and demand for financial assets alter exchange rates. Changes in monetary and fiscal policy alter expected returns and perceived relative risks of financial assets, which in turn alter exchange rates.
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Exchange Rate Determination: The Theoretical Thread The forecasting inadequacies of fundamental theories has led to the growth and popularity of technical analysis, the belief that the study of past price behavior provides insights into future price movements. The primary assumption is that any market driven price (i.e. exchange rates) follows trends.
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The smaller and less liquid markets, however, frequently demonstrate behaviors that seemingly contradict the theory.
The problem lies not in the theory, but in the relevance of the assumptions underlying the theory.
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The currency board regime had eliminated monetary policy alternatives for macroeconomic policy
The Argentine government budget deficit and deficit spending was out of control
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Exhibit 10.6 Daily Exchange Rates: Argentine Pesos per U.S. Dollar
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Forecasting in Practice
Technical analysts, traditionally referred to as chartists, focus on price and volume data to determine past trends that are expected to continue into the future. The single most important element of technical analysis is that future exchange rates are based on the current exchange rate. Exchange rate movements can be subdivided into three periods: Day-to-day Short-term (several days to several months) Long-term
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Forecasting in Practice
The longer the time horizon of the forecast, the more inaccurate the forecast is likely to be. Whereas forecasting for the long run must depend on the economic fundamentals of exchange rate determination, many of the forecast needs of the firm are short to medium term in their time horizon and can be addressed with less theoretical approaches.
Copyright 2010 Pearson Prentice Hall. All rights reserved.
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Technical Analysis
An attempt to exploit recurring and predictable patterns in stock prices Technicians beliefs:
Shifts in market fundamentals can be discerned before their impact is fully reflected in prices Market fundamentals can be perturbed by irrational factors
These presumptions are in contradiction with the weak form of the EMH
Copyright 2010 Pearson Prentice Hall. All rights reserved.
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Recent variations
The Elliot wave theory The theory of Kondratieff waves
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Actual and Simulated Levels for Stock Market Prices of 52 Weeks (Figure 11.7)
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Actual and Simulated Levels for Stock Market Prices of 52 Weeks (Figure 11.8)
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Price Charts
Moving averages Bollinger bands MACD (moving average convergence/divergence) Stochastic indicator (oversold/bought) Volume
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Moving Averages
Average calculated on last n periods such as 200-day or 50-day Price or shorter average crossing the longer average is said to predict a change in direction
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Mini-Case Questions: JP Morgan Chases Forecasting Accuracy How would you actually go about calculating the statistical accuracy of these forecasts? Would Vesi have been better off using the current spot rate as the forecast of the future spot rate, 90 days out? Forecasting the future is obviously a daunting challenge. All things considered, how well do you think JPMC is doing? If you were Vesi, what would you conclude about the relative accuracy of JPMCs spot rate forecasts?
Copyright 2010 Pearson Prentice Hall. All rights reserved.
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Chapter 10
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Exhibit 2 Monthly Average Exchange Rates: Japanese Yen per U.S. Dollar
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