Relative Economic Strength vs. Capital Flows Forecasting

CFA Level III
#1

​4.6.9. Approaches to Forecasting Exchange Rates

What’s the main difference between Relative Economic Strength Approach and Capital Flows Forecasting Approach? I read the curriculum twice but still find it’s pretty similiar. Can any smarter guy advise? Thank you.

#2

The capital flows forecasting approach focuses on expected capital flows, particularly long-term flows such as equity investment and foreign direct investment (FDI). - Curriculum

Why curriculum only mention equity investment instead of treasury? For 2014 2H and 2015 1Q, isn’t cash flow going to buy US treasury making USD strenghening? (One of major reason)

#3

Capital flows forecasting more focusing on FDI?

#4

I believe they are highly correlated. Can anyone think one scenario two appraoch will have different outcome?

#5

can anyone answer this please? I am confused too. Both seem pretty similar.

#6

You have three general “methods” for forecasting changes in exchange rates:

  1. Purchasing Power Parity: Which simply states that changes in exchange rates are directly related to inflation differentials between countries --> higher inflation = currency depreciation

  2. Relative Economic Strength: Capital flows toward growing economies. When you have a growing economy, the demand for funds will increase relative to the supply of funds, which leads to higher interest rates. Higher interest rates will entice foreign investors to demand debt instruments denominated in the growing economy’s currency. This increased demand from foreign investors leads to appreciation of the growing economy’s currency. The main point here to differentiate from the Capital Flows Model: HIGHER interest rates = Currency Appreciation

  3. Capital Flows: Capital inflows are driven by equity/foreign direct investment. Equity/direct investments thrive in economies that exhibit lower interest rates, as low interest rates promote economic growth, lower required rates of return, and increased stock $'s. As capital flows into the economy to make direct investments or purchase equity securities, the currency appreciates. The main point here to differentiate from the RES Model: LOWER interest rates = Currency Appreciation