Predicting rupee movements based on global market indicators

Abstract

The system of global financial markets has undergone rapid changes since the days of the Bretton woods system of fixed exchange rates and strongly limited capital mobility. The markets today are largely globalized as well as liberalized. There is seamless flow of capital across all kinds of boundaries, which has increased the quantity of money at risk worldwide. It has been seen that some of the worst economic crises that countries have experienced have originated due to the pressure on their domestic currency in the international market. The higher the pressures on the currency, the stronger the vicious circle of successive rounds of depreciation, domestic failures, economic worsening and investors panicking, the longer will the financial crisis last, the deeper will it be and the greater is the danger of contagion. In such a situation, institutional money managers at investment banks or asset management houses desire to make a decision about their foreign currency exposures and the choice of hedging strategies. Risk managers use exchange rate predictions when deciding if (and when) to hedge currency movements. Portfolio managers use exchange rate predictions to obtain expected returns on foreign assets. Academics test their models of exchange rate determination on the basis of their ability to predict exchange rate movements. The success of these movements is measured alone by the returns that these market participants make compared to those who don’t undertake such a study of the movements in currency. Some of the methods that are used for this purpose involve making use of macroeconomic indicators such as Purchasing Power Parity (PPP), inflation and other economic indicators or the logic of covered interest arbitrage using interest rates prevalent in the two countries. While it may be possible for currency arbitrageurs to make profits when these relationships are momentarily violated, for all practical purposes it is impossible for money managers to achieve incremental returns by simply transferring funds from one country to another to take advantage of higher interest rates. Many analysts believe that exchange rate movements are a result of the interaction of many complex domestic as well as global economic factors. Some of the best known works in this field model exchange rates as outputs of a random-walk-forecast. We undertook a study of all these possible factors, specifically in the context of the Indian rupee, to model its fluctuations based on global economic indicators.