Factors In Predicting Trends Pound Dollar Exchange Rates Finance Essay - Free Essay Example

Sample details Pages: 6 Words: 1890 Downloads: 10 Date added: 2017/06/26 Category Finance Essay Type Narrative essay Did you like this example? The Foreign Exchange market or FOREX as its popularly known has grown vastly over the past few decades. It has been through a lot of rocky patches is one of the most volatile markets, but is still one of the most highly traded most liquid markets in any country is worth trillions of dollars. According to www.investorwords.com[1]Forex trading is estimated at around $4 trillion everyday. Don’t waste time! Our writers will create an original "Factors In Predicting Trends Pound Dollar Exchange Rates Finance Essay" essay for you Create order It is a non-stop process is carried out round the clock due to the various time zones. What makes FOREX so desirable to all parties involved is predicting fluctuations in movements of exchange rates which helps them make huge short-term profits, acquire foreign currency at bargain rates avoid huge losses at any given point. FOREX is an excellent investment opportunity for risk seeking investors who like engaging in speculation. There are various theories underlining FOREX such as the ones shown by Agarwal et al. (2002) for the law of one price which states that identical products in perfectly competitive markets should sell at the same base price when prices are expressed in the same denominations. The interest rate effects theory states that FOREX rates would become stable at a juncture where there would be equality of interest when capital is allowed to freely flow in out of a country. The Purchasing Power Parity (PPP) rule states that if inflation forces the prices to increase in one country but not in another one, the purchasing power would change which subsequently would lead to exchange rates changes reflecting the purchasing power of the currencies involved. The International Fisher Effect tells us that the change in interest rates should move in opposite direction of the change in spot of two currencies should be equal to it. There are various forces like Demand Supply, stock markets, confidence in a currency, business environment, political factors which work behind FOREX. Ehrmann and Fratzscher (2005) incorporate in their paper that news about fundamental factors have significant impact on the exchange rates. They concluded in their paper that an environment with high market uncertainty large exchange rate volatility are hugely impacted by news about fundamentals. They also drew attention to the fact that according to their study large unexpected news or negative news had a relatively larger effect on exchange rates than positive or smaller unexpected news. Hartley P. (1982) says that there are numerous models which imply that movements in FOREX are due to the way monetary policy is adopted in different countries. A huge amount of negative vibes has been existent ever since Meese Rogoff (1983) findings that fundamentals based models don`t succeed in outperforming a random walk for exchange rates. They reported in their findings that the reason why monetary models perform poorly is that disturbances impinging on exchange markets are predominantly rea l. As always there have been huge debates about the validity of the results by Meese Rogoff. Some authors like Diebold et al (1994) support the findings whereas Macdonald Marsh (1997) tell us through studies done by Macdonald Taylor (1994) Mark (1995) that fundamental based models can outperform a random walk can over long term period. This gave rise to explanations which were generally non-fundamental in nature, like Macdonald Marsh (1997) who shed insight into the work done by Frankel Rose (1994) on microstructure hypothesis in their research. Conceptual Framework: The Macro-economic or fundamental factors are factors that affect the economy of the country such as the financial markets viz. stock and derivatives markets, bond markets, etc., inflation, the monetary policy of the government which includes regulating interest rates, the fiscal policy which shows government income and expenditure, the growth rate of the economy of the country .i.e. GDP, Balance of Payments Position which shows the import and export surplus or deficit of the country, etc. The Macro-economic or fundamental factors and technical analysis are the independent variables that will be used for study in the research, while the trend analysis is used as the dependant variable. Having a look at the factors that affect the exchange rate:- Business Environment :- this pre-dominantly means the monetary fiscal policy as positive indications of government policies increase the demand for a particular currency as more more people want to invest is a government friendly country. FDI is for taking advantage of comparative advantages economies of scale. Political factors :- FOREX rates are heavily dependant on the success of a government may fluctuate depending upon if there is a stable govt. at the centre or not. A threat to any coalition govt. will seriously effect the FOREX rates. Stock market :- most of the major indices have direct correlation with FOREX rates, like the Dow is the most influential index on the dollar. Economic Data:- economic data like GDP, CPI, Productivity etc effect the exchange rate massively. Confidence in a currency is the greatest influence on currency exchange. Growth Productivity of an economy :- an increase in the growth rate productivity rate , especially in the traded sector, has a major impact on the exchange rates. Government Influence :- the government also plays an important role in the exchange rate of their currency as it controls a lot of factors that influence exchange rates like money supply, lending rates etc.. A govt. may buy or sell FOREX just to maintain a balance or for the benefits of importers or exporters. Methodology The research methodology adopted in this study is a very simplistic approach to find the relationship between different variables concerned and does not exactly represent any work done in the past. The models used in most of the studies till now have made changes to regression models to incorporate a lot more terms and information, and thus are much more complicated. The model that will be used in this study is the Ordinary Least Squares (OLS) regression model in the form of a multiple linear regression. This model would help find the dependence of foreign exchange rates on multiple macroeconomic factors over the long run. The regression would be run twice, once with the macroeconomic variables of the US and the pound sterling-Dollar exchange rate denominated in US dollar and again with the variables of the UK area and Dollar-pound sterling exchange rate denominated in pounds. The model used is as follows: The Ordinary Least Squares (OLS) model: Where, Represents the sterling pound-dollar exchange rate, Represents the interest rate, Represents the percentage change in the inflation rate (CPI), is the percentage change in the economic growth (GDP), are the regression coefficients of , respectively, that need to be determined by estimation in the regression model, is an intercept or a constant, accounts for errors and is assumed to have mean zero and is uncorrelated with the regressors. The Pound sterling-Dollar exchange rate is considered for this study to represent the foreign exchange market for the purpose of achieving the objectives of this paper. The data consisting of the macroeconomic variables would include figures from the United Kingdom area as well as the US. The figures are of a daily frequency, and spread across the past 12 years, February 1999- February 2011. This would help us to show the relation in an advanced way as it would show both the exchange rate s short term as well as long term reaction to new figures on a regular basis every time they are released. By using data of a daily frequency, the movement of the exchange rate, after the effect of new figures released has been absorbed in the market, would give clear indications of the effect of the change over the longer term. Hypothesis: In order to achieve the objective of this study, a null hypothesis is used, which either would be accepted or rejected on the basis of the regression models results. The hypotheses are as follows: H0: Any fundamental (macroeconomic) factor has no relation with, and hence, has no influence on the Sterling pound-Dollar exchange rate movements. H1: Fundamental (macroeconomic) factors have an influence on the Sterling pound-Dollar exchange rate movements. Thus in order to support this null hypothesis, the coefficients associated with each of the independent variable would require to be near or equal to zero and the p-values of the coefficients should not be significantly different from zero. Independent variables: Growth Rate: The growth rates of the United Kingdom and the US area are represented by Gross Domestic Product (GDP) which is the market value of goods and services produced in country in a year. Interest rates: For the US, interest rates are represented by the Federal Funds rate which is the interest rate at which depository institutions, like banks, lend balances at the Federal Reserve to other depository institutions overnight, while for the United Kingdom interest rates are represented by the Marginal lending rate of the Bank of England, which is the interest rate at which overnight liquidity is lent by the national central banks to eligible counterparties. Inflation rates: The inflation rate in the US is represented by the Consumer Price Index (CPI) which is a measure of the average change in the prices of consumer items over time and includes all urban customers and their buying habits. While for the Sterling pound, it is the Retail Price Index (RPI). Dependent variable: As mentioned earlier, there is a single dependant variable which is the exchange rate. The regression would once be run with the sterling pound-Dollar exchange rate as the dependant variable and the second time it would be replaced with the Dollar-Sterling pound exchange rate. Data Sources and Sample Selection The data for this study would be collected from DataStream, the sources of which are reliable databases of the Bank of England, US Federal Bank, etc. The data consists of the exchange rate of the pound sterling against the US dollar (denominated in US$) and the US dollar against the Pound Sterling (denominated in GBP). Interest rates in the form of Federal funds rates for the US and Marginal Lending rates for the sterling pound area have been used. Inflation is represented by the CPI (all urban items) for the US and Retail Price Index (RPI) for the United Kingdom. The GDP figures of the US and the United Kingdom have been taken as the economic growth indicator of the respective countries. The sample consists of the daily figures of exchange rates and interest rates, monthly figures of the CPI and quarterly figures of the GDP, from February 1999- February 2011. Conclusion Given the importance huge trading in FOREX a lot of research has been carried out in this field. Past literatures on FOREX have shed light into the various aspects of the markets its determinants. As usual there have been debates about whether fundamental factors or technical factors have had a larger impact on FOREX market due to the various variables involved. I would be focusing on the fundamental factors would be using the Ordinary Least Squares (OLS) Model to test my data, which would be collected from `DataStream` all other reliable sources. The FOREX market continues to grow in volume importance day by day due to its high reward nature but can be a slippery slope as well for some who take high risk for making a quick buck.