Exchange Rate Based On Economic Factors Finance Essay - Free Essay Example

Exchange rate movements can have significant impact on a companys return especially for multinational companies and companies that involved heavily in export and import of goods. A small change in exchange rate would impact directly to the companys performance. Therefore these companies often use derivatives securities such as options, forwards and futures to hedge or mitigate risk arising from exchange rate movements. Investors also use these tools to speculate and hope for profit from fluctuations in exchange rates. If investors predicted accurately on future exchange rate then this would provide a favourable return on their investment portfolio. In this paper, we will examine on how economic factors relate to exchange rate movements and use it to forecast. Firstly, we will look at four different types of exchange rate regime and how the exchange rate is determined. Next, we will examine Purchasing Power Parity (PPP) and we use it to calculate whether a currency is undervalued or overvalued. After that, we look at how Balance of Payment (BOP) could be one of the factors that influences exchange rate movements. Under BOP trade flow model, we use the trade flow and capital market participants to be the factors that determine the exchange rate equilibrium. We then use this model to predict future exchange rate movements when there is a shock in economic activity. Lastly, we will examine the relat ionship between official interest rate and exchange rate and use the interest rate differentials theory to predict future exchange rate. 1.1 TYPES OF EXCHANGE RATE 1.1.1 Free Floating Exchange Rate Regime Under this type of exchange rate, the value of a nations currency is fully determined by the market demand and supply in a freely competitive market. Under no government intervention in the exchange rate determination, the rate fluctuates purely based on the conditions of demand and supply. The benefit of choosing this type of exchange rate over fixed exchange rate regime is that the country will not suffer from balance of payments crisis because the currency will adjust accordingly and no reserves are being used to maintain its pegged value, but on the other hand, it causes lack of confidence to importer or exporter as the currency has the potential to fluctuate widely in a short period during period of turbulence. 1994 economic crisis in Mexico is a good example to explain balance of payment crisis due to its fixed exchange rate regime. Mexican peso had to be devalued immediately when Mexico government run out of its foreign reserves to maintain its fixed exchange rate regime, se e Whitt (1996). However, many nations will prefer managed floating exchange rate instead of free floating exchange rate as they can intervene the market and reduce the fluctuation of its currency. 1.2 Managed Floating Exchange Rate Regime This type of exchange rate is similar to free floating exchange rate, the monetary authorities or central bank will manage and control its fluctuation rather than simply leaving it to be set by the market. The central bank can alter its official interest rates or uses its reserves to influence the value of its currency in the short and long run. We will further discuss interest rates and BOP approach in chapter 2.2 and 2.3. 1.1.3 Fixed and Semi-Fixed Exchange Rate Regime Fixed exchange rate is often called as pegged exchange rate; the exchange rate is set at a declared par value and maintained by the authorities or central bank. The rate will not fluctuate in daily basis as the intervention from the authorities will fix the exchange rate by buying or selling its currency. The central bank must hold large foreign currency reserves to mitigate shocks in supply and demand. Third world countries often use fixed exchange rate to build confidence in investors and avoid bubbles in foreign market. Developing countries can use it to avoid out-of-control-inflation. In term of semi-fixed exchange rate regime, the value of a countrys currency is allowed to float between the permitted bands of fluctuation. Same as fixed exchange rate regime, central bank has to intervene in the foreign exchange market to ensure that the exchange rate stays within the specified bands and it can be done by buying or selling its countrys currency. In other words, central bank a cts as a dominant investor and has the ability to influence market exchange rate. However, the fixed exchange rate regime can backfire, if the foreign exchange market value of the currency is not reflected by the pegged rate. This will lead to investors to trade the currency in the black market; the currency will not be traded at the pegged rate, instead at market value. If the countrys currency were set its rate wrongly, take the case when central bank set its rate above equilibrium (an overvalued currency), in the long period of time, the monetary authorities will suffer from foreign reserves crisis. They must then either devalue their currency or change the regime from fixed to floating type of exchange rate. Please refer to Argentine economic crisis (1999 -2002) and Mexican peso crisis (1994) for a better understanding in the foreign reserves crisis. CHAPTER 2: FACTORS THAT INFLUENCE EXCHANGE RATE In this chapter, we first look at how Purchasing Power Parity (PPP) could be used to analyse the movements in exchange rate and hence predict future spot rate. The reason we start with PPP is that PPP perhaps covers the most fundamental approach to assess long-term value in the foreign exchange market. In order to develop more sophisticated models of exchange rate determination, we must first be able to grip a good understanding about the basic notion of PPP, theories and assumption of this approach. We look at three main types of evaluating a nations currency which are absolute purchasing power parity, real exchange rate and relative purchasing power parity. We then use them to determine whether the currency is overvalued or undervalued. Next, we consider balance of payment (BOP) approach in our study of movements in exchange rate. In this section, we begin with the BOP structure and classification and followed by BOP flow model of exchange rate determination. In this flow m odel, we first look at how trade flow determines the exchange rate equilibrium and later we combine with capital market participants to produce a more complete BOP flow model. We also examine in how exchange rate responds to a shock in economic activity based on the BOP flow model. We look at interest rates as predictor of exchange rate movements in section 2.3. We start with two fundamental interest rate hypotheses which are covered interest rate parity (CIP) and uncovered interest rate parity (UIP) and use them to determine the expected rate of depreciation or appreciation of a currency. Next, we discuss about how interest rate differentials cause movement in capital flow from one country to another and hence affect the exchange rate. 2.1 PURCHASING POWER PARITY (PPP) PPP is one the oldest method to forecast the long-term value of a foreign exchange and the foundation of PPP is based on the assumption of law of one price. Law of one price simply states that in an efficient market, all identical tradable goods must only have one price. This law implies that exchange rates should be adjusted to compensate for price differentials across nations; price of goods and services should cost the same in all nations when prices are measured in a common currency. However, law of one price does not always hold especially in the short time frame. At a point in time, the price for the same item in different market may not be unique if the price measured in a single currency. Antweiler (2009) stated that changes in exchange rate in the short run are news-driven whereas PPP describes the long run behaviour of the exchange rate. The economic forces behind PPP will eventually even out the differences in purchasing power of currencies. As mentioned earlier, we only consider the long-term value of the exchange rate in this paper hence this problem will no longer hold as the price will adjust accordingly. PPP divided into two categories, absolute purchasing power parity and relative purchasing power parity. 2.1.1 Absolute Purchasing Power Parity In order to derive the equation for absolute purchasing power parity, firstly we need to use the assumption of law of one price to equate price of one good expressed in two different currencies. Equation (2.1) holds with respect to all tradable goods and services consumed in two countries. Pi is the price of i good and service in domestic country and with asterisks is the price of goods and services in foreign countries. S is the nominal exchange rate between the domestic country and foreign country, expressed as price of a unit of foreign currency, measured in units of domestic currency. However, we assumed that there are no transaction costs such as transportation and tariffs in equation (2.1). It will be more appropriate to calculate the estimated exchange rate based on PPP if we use a basket of tradable goods and services as our measurement in both countries instead of a single tradable good. P and P* refer to the domestic and foreign countrys price of a basket of tra dable goods and services. Equation (2.2) is often called absolute purchasing power parity. Absolute purchasing power parity follows the proposition that a group of tradable products will have the same cost in every country if the costs are converted in a common currency. If the nominal exchange rate calculated based on equation (2.2) is greater (lower) than the actual exchange rate, it suggests that the domestic currency is undervalued (overvalued) against the foreign currency. 2.1.2 Real Exchange Rate PPP however does not always hold in practice, in this case, many economists wish to measure deviation from PPP and the most popular method used for this measurement is called real exchange rate: Real exchange rate, Q, is defined as the nominal exchange rate that takes inflation differential between two currencies into account. For the simplicity, we use Big Mac, the McDonalds sandwich, as our example to explain how economists use this approach to determine whether one currency is overvalued or undervalued. Let the United Kingdom and the United States be the domestic and foreign country used in our example. We also assume it costs pound;1 to buy a Big Mac in United Kingdom, UK and $1.5 in United States, US. In this case nominal exchange rate is said to be 0.667 (pound;1 = $1.50). If absolute PPP holds, then the value for Q is said to be one; the burger would cost the same in United States and United Kingdom since the burger is identical in both countries. However, if nominal exch ange rate remains constant, i.e. pound;1 = $1.50, and Big Mac costs pound;1.2 in United Kingdom, this implies that it costs 20 percent more in United Kingdom, suggesting that the pound is overvalued by 20 percent relative to US dollar, hence the absolute PPP no longer holds (Q is not equal to one). In this case, there will be an upward pressure on the demand for US dollar; one would buy the burger in US at the price equal to 1 pound (pound;1=$1.50) instead of buying it in UK which costs pound;1.20. Increase in demand for US dollar causes upward pressure on the nominal exchange rate until the price in US and UK is the same, the real exchange rate returns to 1. To further our study on Big Mac, in table 1, page 11, we show the prices of Big Mac in 17 countries expressed in term of US Dollars based on the actual exchange rate as of 4 July 1995. Since the Big Macs are identical, whether purchased in Sydney, San Francisco or Tokyo, they should theoretically cost the same or at least ro ughly the same price according to the law of one price. The Economist magazine found out that the law of one price does not hold when applied to Big Mac, as substantial deviations from PPP exist. Nevertheless, Cumby (1993) study the behaviour of Big Mac prices in 25 countries over seven-year period starting from 1987. The study found that 70-percent of the gap between actual exchange rate and their estimated Purchasing Power McParity values was removed. Purchasing Power McParity works exactly the same as PPP, instead of using a basket of tradable goods and services, it uses Big Mac index which published by The Economist. Table 1 Currency Big Mac Price Implied PPP of the US$ Actual Exchange rate % Over (+)/ In Local Currency In US Dollar Terms as of 4/7/95 Under(-) Valuation Hong Kong Hk$9.50 1.23 4.09 7.73 -47 Indonesia 3900 1.75 1681 2231 -25 Australia A$2.45 1.82 1.06 1.35 -22 Canada C$2.77 1.99 1.19 1.39 -14 Singapore S$2.95 2.10 1.27 1.40 -9 US $2.32 2.32 Italy Lire 4500 2.64 1940 1702 +14 Britain pound; 1.74 2.80 1.33 1.61 +21 Spain Pta 3.55 2.86 153 124 +23 S. Korea Won 2300 2.99 991 769 +29 Holland FI 5.45 3.53 2.35 1.55 +52 Sweden Skr 26.0 3.54 11.2 7.34 +53 Belgium Bfr 109 3.84 47.0 28.4 +66 France FFr 18.5 3.85 7.97 4.80 +66 Germany DM 4.80 3.48 2.07 1.38 +50 Japan  ¥391 4.65 169 84.2 +100 Denmark Dkr 26.75 4.92 11.5 5.43 +112 Source: McDonalds; The Economist, April 15, 1995 2.1.3 Relative Purchasing Power Parity There is another way of measuring real exchange rate which is known as relative purchasing power parity. As before, it measures the relationship between two countries relative inflation rates and the change in the exchange rate, we then use it to predict the future exchange rate. Relative purchasing power parity is defined as the rate of change in price level of a basket of tradable goods and services in one country relative to the price level in another determines the rate of change of the exchange rate between the two countries currencies. Equation (2.4) is obtained by taking logs of Equation (2.2) and the reason of doing so is one could measures the exchange rate in term of rates of growth when we apply derivative on natural logarithm (equation (2.5)). In equation (2.4), s is defined as the log of nominal exchange rate, p and p* represent the log of price in domestic country and foreign country. Next, if we apply derivative on equation (2.4), we arrived at the proportiona l rate of change, which is also known as relative purchasing power parity. The equation as above says that rate of change of currency, ds is equal home countrys inflation rate, dp minus foreign inflation rate, dp*. One way to interpret this relationship is simply saying when prices rise more rapidly in home country than foreign country then it is said that the domestic money losses its value relative to the foreign money or decrease in exchange rate, and vice-versa. Equation (2.5) is also valid for relaxing the assumption of no transaction cost when the transaction cost is proportional to the value of the goods. Take logarithm in Equation (2.6) we have: Since k is a constant, we end up with the same result as equation (2.5) simply because it vanishes when we differentiating a constant, k. In other words, proportional transaction costs have no effects on the relative purchasing power parity. In this section, we discussed how price differentials could be related to nominal exchange rate. Investors could use equations (2.2), (2.3) and (2.5) to predict the future spot rate movements. It is difficult to measure the change in price of a basket of tradable goods and services in both countries, therefore investors often use Consumer Price Index (CPI), Export Price Index (EPI) or Import Price Index in evaluating the estimated exchange rate based on these equations and make appropriate investment decision. In graph 1, we show a strong positive correlation between YEN ¥/USD$ exchange rate and Japan export prices (all commodities) from 2001 to 2010. However, the drawback of using Japan Export Price Index (EPI) is that EPI unable to tell us about the magnitude of the change in exchange rate corresponded to a unit change in export price. We note that the magnitude of the change in YEN ¥/USD$ exchange rates do not correspond well to the Japan export prices in year 2008 and this might be reason of the effect on global financial crisis in year 2007 to 2010. There are number of debates in the international economics on the issue of whether PPP is a valid tool for forecasting exchange rate. PPP could be calculated based on CPI, EPI, wholesale price indexes, wages or other set of price or cost indexes. Unfortunately, each approach may provide different set of answers as to whether a currency is undervalued or overvalued and this might lead to disaster investment decision if an investor chose a wrong set of index. In the effort of calculating relative PPP, we cannot fully rely on the set of price indexes as different countries may have different national preference and tastes, and hence different weight in their price indexes. Therefore, if two nations preference and tastes are not in common, using price indexes may not be the best approach to forecast its exchange rate. Apart from choosing appropriate set of price indexes, there is another problem called the base-year problem. Selecting different base-year could end up the same puzzle as before. However, this problem could be resolved by selecting the base year when both countries current account balance last attained is near zero. 2.2 BALANCE OF PAYMENTS (BOP) The BOP model of exchange rate determination was originally developed in the 1930s and 1940s by Robinson (1937), Machlup (1939), and Haberler (1949). In this section, we explain the meaning of BOP and its accounts, current account and capital and financial accounts. Next, we look at the basic model of BOP which only considers trade flow as the determination of exchange rate then we slowly develop to more complete BOP flow model which able to tell us the future exchange rate movements for a given shock in economy activity. 2.2.1 BOP Structure and Classification BOP is defined as a statistical statement that systematically summarises, for a specific period, the economic transactions of an economy with the rest of the world by IMF (please refer to IMF Balance of Payments Manual, Fifth Edition, Chapter 2 Conceptual Framework, page 6). The transactions refer to receipts and payments of all of the money coming in a country from abroad and going out from the country to abroad for a specific period. Examples of these transactions are payments for the countrys export and imports of goods, services and financial capital. Transactions that lead to a receipt of payment from foreigners (payment to foreigners) are recorded in the BOPs accounts as a credit (debit). BOP accounts are divided into two broad part, current account and capital and financial accounts. Current account deals with payments for import and export goods and services, income from abroad such as interest and dividends, and transfer payments. In order to figure out whether the bala nce of the current account of a country has a deficit or a surplus, one can calculate it using the equation as follow (IMF Balance of Payments Manual, Fifth Edition, Appendices, page 158): In other words, current account balance (CAB) is equal to the sum of net value of exports (X) and imports (IM) goods and services, net income abroad (NY) and net current transfer(NCT). A surplus of CAB indicates that the economy of a country being a net creditor to the rest of the world. This means that the country is providing resources to other economies more than it received, in return, they owes money to the country. This situation is often called as favourable balance and it indicates that there is an upward pressure on demand of the countrys currency, which leads to an increase in the value of the currency. On the other hand, deficit of CAB mirror the economy of a country being a net debtor to the rest of the world. It is said that the country is investing more in its country than saving and it uses resources from other economies to meet its domestic consumption and investment requirements. On the other part of BOP, capital and financial accounts which record the transactions related to international movements of ownership of financial assets. One can easily break capital and financial account into four categories; direct investment, portfolio investment, other investments and reserves account, refer to IMF Balance of Payments Manual, Fifth Edition, Chapter 3 Structure and Classification, page 77. Direct investment records the transactions on long term capital investment, such as purchase of fixed assets in foreign countries or domestic country by any residents or non-residents. Portfolio investment is referred to the transactions of buying or selling shares and bonds in financial markets. Other investments are referred to capital flows into banks or banks provide loans to residents or foreign investors. After the initial investment, any incomes or interest re payments generated by these assets are recorded in the current account. Reserve account is controlled by monetary authorities and these reserves are used for financing or regulating payments imbalances or for other purpose, refer to IMF Balance of Payments Manual, Fifth Edition, Chapter 3 Structure and Classification page 80. Any payment imbalances will usually lead to change in the holding of reserves as monetary authorities will use it for official market intervention to influence the spot rate. If a domestic resident purchased (sold) foreign assets or foreign resident sold his/her (purchased) assets in the domestic economy then it is referred to be capital outflow (capital inflow) and it is recorded as debit (credit) entry in capital and financial accounts. 2.2.2 BOP Flow Model In this section, we will use BOP flow model to determine and affect the value of an exchange rate. We will first be looking at the simple trade flow model of exchange rate determination and how do monetary authorities intervene in the foreign market under fixed and semi fixed exchange rate regime to manage its exchange rate. Next we will include capital market participants into our consideration of modelling exchange rate equilibrium and predict future spot rate movements. We also examine in how exchange rate respond to a shock in economy or large capital movements. The diagram above shows us how the equilibrium MYR/US$ exchange rate is determined under three different exchange rate regimes. On the vertical axis, we plot the MYR/US$ exchange rate and on the horizontal axis we have the quantity of US dollar printed by US government in a specific time frame. In this model, we shall only consider the demand of US dollar (D$) is affected by the Malaysian demand for US goods. To expl ain this, Malaysian residents must first exchange Ringgit Malaysia in the foreign exchange market before they could make payments for the US goods they wish to purchase. In the same vein, the supply of US dollar (S$) is only affected by the demand of Malaysian goods by US residents. In the free floating exchange rate regime, if the demand and supply for dollars is only affected by the trade flows, it should be in the equilibrium point (QE,E2) at all time, which is the intersection between supply (S$) and demand (D$) for dollars. To explain this phenomenon, if we look at the exchange rates above equilibrium, there is an excess of supply of US dollar (S$) and market will push the exchange rate down to equilibrium point, and vice-versa. Let us assume that the exchange rate regime between MYR and US Dollar were semi fixed and the permitted band of fluctuation was E1 and E3. If the equilibrium exchange rate is within the bands therefore no intervention by central bank is required. If the demand shifted above (below) the allowed band of fluctuation,D1$ (D2$), then the central bank must sells (buys) its own currency on the foreign exchange market and restore the equilibrium within the band. In the fixed exchange rate regime, if the MYR/US$ exchange rate were pegged at an artificially high level such as E3, then flow supply for dollars would exceed the flow demand of dollars and the gap between A an B would be the markets excess supply for dollars (QB -QA). In order to maintain at the level E3, the central bank must then buys its own currency on the foreign exchange market in return for the currency to which it is pegged. Graph 2 shows the spot rate between Malaysia and US (MYR/US$) for the period between 1st January 2004 and 31th December 2007. Between 1998 and 2004, the exchange rate between MYR and US Dollar was pegged wrongly at the rate above market equilibrium, 3.80 ($1=MYR 3.80) by Bank Negara Malaysia, Talib (2004). On 21th July 2005, Malaysia and US government agreed to remove this pegged regime and adopted managed float exchange rate regime. Since then, the value depreciated significantly and this indicates that the spot rate was pegged above the market equilibrium. In the BOP model, capital flows are important in analysing the exchange rate movements, especially in the short and intermediate-term horizon, Siourounis (2003). The diagram below shows how capital market participants could influence the value exchange rates. For the purpose of analysing, we divide capital participants into two groups; one seeking for capital gains (currency speculators) and other one is seeking for interest rate differentials (international investor). In the following section, we look at the model on how currency speculators influence the exchange rate whereas the interest rate differentials as a model to predict exchange rate movements will be discussed in section 2.3.3. The diagram above shows the exchange rate correspond to the demand and supply of dollars provided by currency speculators. On the right (left) side of vertical axis, the SP$ represented the supply (demand) of US dollars provided by currency speculators. Let the current spot rate MYR/US$ be the point where SP$ intersects y axis, Ee. If speculators predict the expectation of future spot rate be more than Ee, say E2, then currency speculators will convert Ringgit Malaysia to US dollars at the present and it convert back when the market rose above the current equilibrium point. In other words, currency speculators will be willing to supply more of US dollars in the future if the expected spot rate lies above Ee. The opposite case will be the same if expected spot rate lies below Ee. Complete BOP flow model of exchange rate determination is obtained by combining BOP trade flow model of exchange rate determination, diagram 1, currency speculation and exchange rate determination, diagram 2 and interest rate differentials as a model of exchange rate det ermination, diagram 5. This model allows us to study the interaction of commercial traders and capital market participants set the equilibrium level of spot rate. Diagram 3 (a) is the copy of the trade flow model shown in diagram 1 where exchange rate is determined by only trade demand and supply of US dollars. In order to capture the gaps between trade demand and trade supply we plot excess commercial demand curve for dollars, ED$ in diagram 3 (b), (D$-S$) and relate it to the supply of US dollars curve, SP1$. SP1$ curve is influenced by capital market participants, which consist of international investors and currency speculators. Plot ED$ and SP1$ in a same graph, we obtain the complete BOP flow model of exchange rate determination. In this model, the new equilibrium level of exchange rate is obtained by finding the intersection point between ED$ and SP1$. In other words, it is the intersection point between the net supply of dollars provided by capital market participants and the excess of commercial demand for dollars by commercial traders. However, investors are more interested in how exchange rates respond to shift in domestic and foreign economic activity, change in market expectations of future spot rates and independent shift in trade flows. Using BOP flow model of exchange rate (2), diagram 4 allows us to predict the future exchange rate movements and its direction caused by these shocks. Let us assume the SP2$ and ED1$ be the current supply and demand for US dollars respectively and the corresponding spot rate is at E1. If there is an increase in Malaysian economic activity (case 1), more Malaysian residents are willing to spend, this would imply that a relative increase in Malaysian demand for US goods and services. In turn, it causes an overall rightward shift of excess commercial demand for US dollars from ED1$ to ED2S. The market will respond to the change in Malaysian economic activity and restore its equilibrium at a higher rate, E2. In other words, greater amount of US dollars are injected by Malaysian residents whilst the supply curve remains constant, this caused an increase in the equilibrium spot rate. For the increase in independent trade flows, it will be the same explanation as increase in Malaysian economic activity. In case 2, we assume there is a positive shift in the market expectation of future spot rate and this positive shift would immediately impact the exchange rate. An upward shift in market expectation on the long run equilibrium would shift SP2$ upwards to SP3$, positive shift in capital market participants demand for foreign exchange resulting an immediately appreciation in the spot rate. Siourounis (2003) shows the empirical evidence for a positive shock to net purchase of US equities by UK, Germany and Switzerland have a significant and immediate effect on exchange rate that lasts between 10 and 17 months. In graph 3, we show there is a significant trend between USD$/AUD$ exchange r ate and Australias current account seasonally adjusted. However the exchange rate does not always associate with the Australias current account balance especially in year 2003 to 2004. This could be the reason when Australia became the host for Ruby World Cup (RWC) 2003. URS Finance and Economics (2004) stated that the results of this event contributed to additional economic activity in the short term throughout the Australian economy in terms of industry sales, employment, GDP and Government revenue. However, URS Finance and Economics (2004) also stated that after 2005 any RWC 2003 influence would have diminished on international visitors. We also note that gap between Australias current account seasonally adjusted and its exchange rate was diminished as well. In graph 4 shows the connection between GBP/MYR exchange rate and Malaysias current account balance. Starting from 2003, the exchange rates move along in the same direction with the movements in Malaysias current account b alance; however, this trend is not as significant as in graph 3. Nevertheless, investors could still use this approach to forecast exchange rate. 2.3 INTEREST RATES In this section, we look at the two main forms of interest rate hypothesis, covered interest rate parity and uncovered interest rate parity. Next, we look at the interest rate differentials as a model to predict future exchange rate movements and how it relates to capital movements from one country to another. 2.3.1 Covered interest rate parity (CIP) To explain the meaning of covered interest rate parity, we shall only consider that investors can either invest in UK (domestic country) or US (foreign country) fixed deposit. Let the UK fixed deposit and US fixed deposit rates be r and r* respectively. For simplicity, we assume that the investor can only convert his/her wealth through a 12-months forward exchange rate if he/she decided to invest in US fixed deposit. On the other hand, if the investor has decided to deposit pound;1 for 12 months in a UK bank which guarantee r interest at the end of the period. Then the pound;1 will accumulated to: For the cases when investor decided to invest pound;1 in US fixed deposit then at the end of 12 months period the pound;1 will accumulate to: Let F denote the forward exchange rate and S be the current spot rate, both measured in the unit of sterling price, (GBP per 1 unit of USD). Under no transaction costs and no arbitrage assumptions, equation (2.10) and equation (2.11) should be equal. We can rewrite the ratio F to S in a linear form. Where f is defined as the forward premium (discount), the ratio by which a countrys (UK) forward exchange rate to another (US) exceed (falls below) its spot rate. We can then substitute equation (2.13) to our equilibrium condition in equation (2.12) and express it as follow: Note that we can subtract one from both sides and r*f is the product of interest rate and forward premium (discount). In general cases, we can easily ignore the last term without affect the equilibrium condition as it is the second order of smallness, unless we are dealing we hyperinflation country then this term can not be ignored as it will be significant in measuring the equilibrium condition. Equation (2.15) states that the domestic interest rate must be higher (lower) than the foreign interest rate by the amount equal to the forward discount (premium) on the domestic currency; this is also known as covered interest rate parity hypothesis. However, empirical evidences show that equation (2.13) does not always hold precisely for the given interest rate differentials and forward premium as it contains transaction costs. In fact, for the fixed exchange rate regime, most researchers found out it felt within a specific bound. We define c to be the cost of carrying out the transaction. The absolute value c is too small that one can not justify it as an unexploited profit opportunity and hence the no arbitrage assumption is still valid in this case. Taylor (1989) studied the unexploited profit opportunities in three different types of economics, stable period, period of turbulences and later period of turbulences of an economic. He concluded that there is no unexploited profit opportunity to be found during the stable period in foreign exchange and this indicates that market is in efficient. He also noted that there is potential to exploit profitable arbitrage opportunity during periods of turbulences. In the later period of turbulences, frequency and size of the profit opportunities in the market had decreased significantly and this suggest that efficiency of the market had increased over time. 2.3.2 Uncovered interest rate parity (UIP) In the covered interest rate parity, we restrict investors to invest in foreign country by changing his/her currency through forward contract whereas in uncovered interest rate parity we do not restrict them. Therefore, investors bear the exchange rate risk as they are not guaranteed the value of exchange rate at the end of 12 months period. As equation (2.12), we replace F by Se where Se represents the expected spot rate at the end of 12 months period. Note that the ratio Se/S is not known; unlike in the equation (2.12), all variables are known at the present. The ratio can be greater (lower) than one if the expected spot rate is higher (lower) than the current spot rate. We can rewrite the ratio as follow: We define ?Se to be the expected rate of depreciation or appreciation of the domestic currency over the 12 months period. Substituting equation (2.17) into equation (2.16), we obtain: As before, we ignore the final term, r*Se in equation (2.18) The equation ab ove states the domestic interest rate must be higher (lower) than the foreign interest rate by the amount equal to the expected rate of depreciation (appreciation) of the domestic currency, this is also known as the uncovered interest rate parity hypothesis. 2.3.3 Interest Rate Differentials as Predictors of Exchange Rate Changes Has been mentioned in the previous section, we will look at how international investors react on the interest rate differentials and hence influence the change in exchange rate. Same as before, we assume a two-country world economy consist of United States and Malaysia. We also assume that investors will invest their wealth in Malaysia if the interest rate in Malaysia is higher than in United State, and vice-versa. Diagram 5 shows the relationship between interest rate differentials and the capital movement between two countries. At the point (iUS iMY)2, investors are indifference if they invested their wealth in Malaysia or United State; the interest in both country is the same. However, when the official interest rate set in United State is higher (lower) than in Malaysia, (iUS iMY)3, then investors will inject more capital into US (Malaysia) from Malaysia (US) as they could earn a higher rate of return. In the second part of the diagram shows the relationship between the size of the change in the spot rate and capital flows.   The slop represents the sensitivity of exchange rate towards capital flow; the higher it is the greater the magnitude of the change in spot rate towards capital flows. In reality, equation (2.20) does not always hold as the expected change in exchange rate predicted by investor does not always match with the spot rate at 12-months period. Therefore, we introduce u as the predictor error in equation (2.21). In evaluating the interest rate differentials as predictors of the change in exchange rate, investors have to measure the size and the direction of the predictor error. Mussa (1979) stated that the interest differentials explain little on the changes in exchange rates; therefore one has to include predictor error when evaluating the change in exchange rate. Graph 5, Appendices shows a positive relationship between MYR/GBP spot rate movements and the difference in interest rate between United Kingdom and Malaysia, (IUK- IMYR). Based on these data, if an currency speculator wishes to predict the future spot rate and he is considering interest rate differentials be the only factor that influences spot rate; he will exchange sterling pound for Ringgit Malaysia at the present and convert back to sterling pound in the future to obtain capital gain as the spot rate has the tendency to drift downward. Conclusion This paper found out that the relative change in price in the short run for both countries with respect to the nominal exchange rate does not hold when we use law of one price. Changes in exchange rate in the short run are news-driven and law of one price is valid when we measure the change in the long run. We also showed that prices of Big Mac in 17 countries did not cost the same price when we measured in term of US dollars. In the long run, studies showed that the gap between actual and estimated exchange rate using Purchasing Power McParity was removed. The real exchange rate is said to be equal to one if the absolute purchasing power holds when we measure the prices in both countries with respect to the nominal spot rate. Under the BOP model, if the spot rate were pegged at the rate above its equilibrium then the central bank would have to buy its own currency on the foreign market in return for the currency to which it is pegged. In corporate to this, we look at the case w hen Malaysia and United State removed the fixed exchange rate regime and adopted managed float exchange rate regime, the exchange rate depreciated significantly. We also discussed how capital market participants react and influence the exchange rate when there is a shock in economy activity. In the interest rates section, we discussed the meaning of covered interest rate parity and uncovered interest rate parity; we then use them as predictor of exchange rate changes. In driving these two hypotheses, we use no arbitrage opportunity assumption. However, studies showed that during period of turbulence there is potential to exploit profitable arbitrage opportunity whereas in the stable period there is no unexploited profit opportunity which indicates that market is in efficient. We also discussed how interest rate differentials will influence capital movements and its sensitivity. If interest rate in domestic country is higher than in foreign country then it will cause capital flow into domestic country by international investors. We also concluded that the greater the sensitivity of change in spot rates towards capital flows, the greater the magnitude of the change. We also showed that there is positive trend between YEN ¥/USD$ exchange rate and Japan export prices (All Commodities), USD$/AUD$ exchange rate and Australia current account seasonally adjusted, GBP/MYR exchange rate and UK current account seasonally adjusted, MYR/GBP exchange rate and interest rate differential.