Analytical Outlook

Research in the area of exchange rates is vast and any attempt to survey the exchange rate theory in its totality would be impossible. Consequently, the objective of Part II is more moderate. It provides a partial review of the classical concepts of exchange rate determination theory and financial theory. In the last few decades, exchange rate economics has seen a number of developments, with substantial contributions to both the theory and empirics of exchange rate determination. Important developments in econometrics and the increasing availability of high-quality data have also been responsible for stimulating the large amount of empirical work on exchange rates. We restrict ourselves to explore the fundamental parity conditions purchasing power parity (PPP) and interest rate parity (IRP) as prerequisites for the understanding of economic equilibrium along with explanations given by economists on why exchange rates in reality do often not behave according to these laws. Furthermore the notions of market efficiency are highlighted, upon which standard finance theory is built. While our understanding of exchange rates has significantly improved, empirical studies have revealed a number of challenges and open questions in the exchange rate debate which have remained unsolved. For instance, while all of the potential explanations for deviations from equilibrium conditions appear fairly reasonable and have theoretical merit, the PPP disconnect and PPP excess volatility puzzles, along with the forward anomalie puzzle have not yet been convincingly explained and continue to puzzle the international economics and finance profession. Furthermore, it is a well-known phenomenon that the forward rate is not an unbiased predictor for the expected exchange rate as the market efficiency hypothesis postulates.