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Valuing a Currency - Outside View

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Valuing a Currency
Aug 2, 2010

Finding the intrinsic value of a stock is something many investors do. Investors attempt to find out the fair value of a company (and its stock price) in order to judge whether a particular stock is a good buy or not. We have definite methods we can use to value stocks. These include discounted cash flow analysis, and use of earnings multiples (like P/E ratios). Because the values depend on the futures earnings of a company, investors will come out with different opinions on what the true value of a stock is. However, most investors will agree that a company does have an intrinsic value.

What about a currency? How can we determine the value of a currency? Economists over time have come up with a variety of explanations for what a currency should be worth. One such is example is purchasing power parity (PPP). According to PPP, the exchange rate between two countries should reflect the relative prices of goods in those countries. Goods should cost around the same in both countries. A 20 km taxi ride in Mumbai may cost around Rs. 300. The same distance taxi ride in London would cost up to £30 or Rs. 2,200! As you can imagine, PPP is not the best predictor of exchange rates.

Another tool used to value currencies is interest rate parity (IRP). According to IRP, the future value of a currency is a function of its interest rate, and forward rates are priced to reflect this. While not delving into the technicalities, this effectively means that a currency’s forward rate is the expected value of the future spot rate. Unfortunately, studies have shown that forward rates are also a poor predictor of future exchange rates. The simple fact is that valuing a currency is extremely difficult. There are no universally agreed methods for valuing a currency (unlike stocks).

Currencies are not predisposed to trend towards some intrinsic value. Instead they move up or down depending on the macroeconomic conditions of a country. What is important in currency analysis is to get the trend correct, rather than come up with a fair value. A couple of months ago, as the Greek sovereign debt crisis unfolded, the euro fell against the dollar. (In the month of May the euro fell from 1.33 to 1.23) Even if an investor could beforehand predict that Greece would get into trouble and the euro would fall, it would be impossible to say how much and to what level the euro would end up at. The only thing they can get right is the direction, rather than the final level.

To predict the direction of a currency, we have to understand what drives currency movements. If a company has a bad earnings report (relative to market expectation), the stock is almost guaranteed to fall upon the announcement of the report. This is true for any stock. Does the same hold for currencies? If a report came out showing that Indian GDP contracted, the rupee would fall against the dollar. This is straightforward and makes sense. How about the reverse?

For example, a report comes out indicating that US GDP contracted (while the market expected an expansion). Most certainly, the American stock market will fall on that day. Given that global stock markets are highly correlated on a day to day basis, the Indian stock market will fall too. What will happen to USDINR in this situation? Many of you may answer that the dollar will fall because the report that triggered this was about US GDP contracting. In reality, the rupee is much more likely to fall in this scenario. Why is this? Well, a lot of American funds are invested in the Indian stock market. When Indian stocks sell off, a significant amount of sales are by foreigners, and the rupees from those sales are sold and converted back to dollars. So, the rupee falls and the dollar rises.

The lesson from this example is that each currency behaves differently. To understand currency movements, one has to know how each one behaves in different situations. In an earlier article, I discussed how the Japanese yen appreciated considerably in the last three years as the global financial crises and subsequent recessions took place. The reason was that many investments were made using borrowed yen. So when markets fell and investments were liquidated, investors had to buy yen to repay their loans.

When it comes to valuing a currency, the best advice is not to do it. Instead, one should understand how currencies move in different scenarios, and that each currency will react differently to the same information. Based on our knowledge of this, we should form forecasts on which way a currency is likely to move, rather than worrying about its true value. This column, A Fresh Perspective, is authored by Asad Dossani. Asad is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!

Disclaimer:
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