Globalization, Gating, and Risk Finance

5Foreign Exchange Models and Prices

Motivation

This chapter outlines the macroeconomic foundations of foreign exchange (FX) markets and FX pricing. Purchasing power parity (PPP) is explained based on the law of one price (LOOP). In addition to asset‐based and monetary approaches to exchange rate determination, various models (e.g., Frenkel–Mussa, Balassa–Samuelson, Dornbusch overshooting, and present value models) are outlined and discussed in light of the empirical evidence used to justify these models. Unlike the currency and FX pricing models to be considered in Chapter 7, the macroeconomic approach provides a broad perspective on the economic factors that determine FX rates.

5.1 Introduction

FX rates, their models, and pricing can be approached from two perspectives. First, a macroeconomic perspective based on the factors that define the economic exchanges between countries; and second, a financial perspective based on exchanges in currency markets, and financial and macroeconomic expectations (see also Chapter 7). In this sense, the market for currencies and the price of FX are both determined by macroeconomic and microeconomic factors. Their integration as a unified model is not usually assessed theoretically, although currency speculators do account for the interactions of macroeconomic and trade‐trend factors, as well as the uncertainties of financial currency markets and their many derivatives and swaps.

Fundamental macroeconomic FX pricing models are based on two ...