The Short Term Behaviour of Exchange Rates: a Middle Ground Approach

Abstract

The understanding of the mechanism determining exchange rates is still an unsolved puzzle in the field of international economics. In the search for the underlying causes of the failure of existing approaches to explain a large proportion of short term exchange rate movements, our review of methodology literature revealed that a significant number of scholars consider the methodological approach employed by mainstream economics as a main cause for the disappointing result of established approaches. In particular, the excessive use of formal modelling and quantitative data as well as the use of oversimplified assumptions has been criticized. In response to this critique we chose to use a more pluralistic approach in our research methodology by employing both qualitative as well as quantitative data analysis. For the analysis of qualitative data, we employed an approach based on grounded theory principles, where we analyze Reuters Foreign exchange market reports. The findings of the qualitative data analysis show that, based on market practitioners commentary, there are two predominant variables affecting exchange rates. First, expectations on interest rate changes appears to be a major variable affecting currency value. An upward revision of interest rate expectations usually suggests an increase in the value of the currency concerned and vice versa. Second major variable affecting exchange rates appear to be global equity returns. In contrast to interest rates, which is a country specific variable, global equity returns is a global variable affecting currencies based on their relative interest rate levels and safe haven attributes. In particular, it is suggested that higher yielding currencies’ value is positive related to global equity returns, while low/lower yielding and safe haven currencies’ value is negatively related to global equity returns. The empirical test we performed to explore the relationship between exchange rates and global equity returns suggest that they are indeed linked. The sign of the relationship depends on the characteristics of the currencies examined. When equity prices increase, currencies with higher interest rates tend to appreciate, whereas currencies with lower interest rates tend to depreciate and vice versa. In addition, the strength of the relationship depends to some extent on relative interest differentials. A stronger relationship is observed when interest differentials are relatively large, while the explanatory power of the model is reduced when interest rate differentials are relatively narrow. Our study presents evidence on the role of stock markets in exchange rate determination which is considerable different to the focus of current theory. Whereas current research focuses on stock market’s relative stock market returns in the respective countries, the findings of this thesis suggests that global stock market returns affect exchange rate movements based on differentiated characteristics of different currencies. Another important contribution of this thesis is that we illustrate the complexity of interactions and links among different variables. For example, whereas interest changes were seen as positively correlated to the home currency value, the relationship was seen as being reversed because of the possible effect of higher interest rates on the subprime crisis. Another example of complex links is the relationship between exchange rates and equity markets. For example, whereas the USD effective exchange rate was not related equity returns during the initial stages of the subprime crises, the strength of the relationship increased significantly when the crisis escalated and the demand for USD increased due to safe haven flows.