Handbook of Exchange Rates

11.4 Conclusion

A primitive notion of currency misalignment linked to the precious metal content of coins has probably been around since the antiquity. The notion that prices of tradable goods are unlikely to diverge substantially across countries can be traced back several centuries and remains a key building block of modern adjusted-PPP or BEER models. Similarly, the link between currency valuation and external imbalances has been observed in ancient times and remains an important building block of the many variants of modern UB models.

In this chapter, we have reviewed the most important families of fair value models currently in use. Most of these models have been developed over the last 20 years. Moreover, we introduce the concept of IFV, a notion of fair value frequently used by financial market participants for short-term investment decisions, but to our knowledge not previously formalized in the academic literature.

Currency fair value modeling has always been a field of interest for policymakers and investors, and fair value estimates are frequently an input for important political or financial decisions. As a result, it is important to highlight the implicit or explicit modeling and implementation choices. The two main families of fair value models used today, UB and BEER, both suffer from major problems.

The UB models are highly sensitive to assumptions of underlying cyclically adjusted external imbalances and appropriate CA targets. Moreover, even small variations in ...