LOS 13: Currency Exchange Rates - Determination and Forecasting

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Uncovered interest rate parity

- is a parity condition stating that the difference in interest rates between two countries is equal to the expected change in exchange rates between the countries' currencies - If this parity does not exist, there is an opportunity to make a risk-free profit using arbitrage techniques - Uncovered interest rate parity assumes that the investor is risk-neutral

Purchasing power parity (PPP)

- is the condition in which a good or service is priced the same in different countries once it is adjusted for exchange rates - Based on the law of one price, identical goods and services trade at the same price across countries - provides a reasonable estimate of fair value of an exchange rate in the long run (but not in the short run)

Covered interest rate parity

- is the relationship between spot and forward rates based on the relative interest rates of the two countries - is a condition in which a foreign money market instrument that is completely hedged against exchange rate risk should provide the same return as a domestic money market instrument

Ex-Ante Version of PPP

- is the same as relative purchasing power parity except that it uses expected inflation instead of actual inflation - if the ex-ante version of relative PPP holds, the real exchange rate will be constant at its equilibrium level

Current account

- measures the exchange of goods, the exchange of services, the exchange of investment income, and unilateral transfers (gifts to and from other nations) - summarizes whether we are selling more goods and services to the rest of the world than we are buying from them (a current account surplus) or buying more from the rest of the world than we are selling to them (a current account deficit)

Capital account

- measures the flow of funds for debt and equity investment into and out of the country - Capital flows tend to be the dominant factor influencing exchange rates in the short term, as capital flows tend to be larger and more rapidly changing than goods flows

Capital flows influence on exchange rates

Capital flows can strain an emerging market through appreciation in currency, increase in indebtedness, market bubbles, domestic credit, or overinvestment in risky projects

Uncovered interest rate parity [example]

Consider Country A where the interest rate is 4%, and Country B where the interest rate is 9%. Under uncovered interest rate parity, currency B is expected to depreciate by 5% annually relative to currency A, so that an investor should be indifferent between investing in Country A or B

Relationships among the various parity conditions 1

Covered interest parity holds by arbitrage. If forward rates are unbiased predictors of future spot rates, uncovered interest rate parity also holds (and vice versa)

DAD

Down ask divide

Macroeconomic balance approach

Estimates how much current exchange rates must adjust to equalize a country's expected current account imbalance and that country's sustainable current account imbalance

Base currency transaction between investor and dealer

For a base currency transaction, investors buy base from dealer at ask price and sell base to dealer at bid price

Price currency transaction between investor and dealer

For a price currency transaction, investors buy price currency from dealer at bid price and sell to dealer at ask price

Forecasting forward exchange rates

Forward exchange rates, on the other hand, can be estimated using covered interest parity, and this relationship is bound by arbitrage

UBM [further explained]

Given a USD/AUD quote, if you want to convert AUD into USD, you are going up the quote (from bottom to top) and, hence, use the bid price

DAD [further explained]

Given a USD/AUD quote, if you want to convert USD into AUD (you are going down the quote—from USD on top to AUD on bottom), use the ask price for that quote

Currencies involved [Interbank spreads]

High-volume currency pairs (e.g., USD/EUR, USD/JPY, and USD/GBP) command lower spreads than do lower-volume currency pairs (e.g., AUD/CAD)

Debt sustainability channel

If a country runs persistent deficits, it will be indebted to foreigners and, eventually, its currency will be depreciated so that the current account deficit narrows

Relationships among the various parity conditions 3

If the ex-ante version of relative PPP as well as the international Fisher relation both hold, uncovered interest rate parity will also hold

UBM

Up bid multiply

Models of exchange rate determination consensus

While models of exchange rate determination disagree on the impact of monetary policy, there is consensus on short-term implications of fiscal policy on currency values: expansionary fiscal policy leads to short-term appreciation of currency values

Dornbusch overshooting model

a restrictive (expansionary) monetary leads to an appreciation (depreciation) of domestic currency in the short term, and then slow depreciation (appreciation) towards the long-term PPP value

Bid-ask spread (for base currency)

ask quote - bid quote

Warning signs of a currency crisis

(1) Deterioration of trade balance (2) Decline in foreign exchange reserves (3) Higher rates of inflation (4) An increase in money supply (5) Private credit growth (6) Boom-bust cycle in financial markets

Current account imbalances effect on exchange rates

(1) Flow supply/demand channel (2) Portfolio balance channel (3) Debt sustainability channel

Monetary models [List]

(1) Pure monetary model (2) Dornbusch overshooting model

Factors that affect the bid-offer spread

(1) Spreads in the interbank market (2) Transaction size (3) Dealer-client relationship

Portfolio balance channel

- A country operating at a trade surplus will have more of a deficit country's currency than it wants, resulting in downward pressure on the deficit country's currency - Countries with current account surpluses usually have capital account deficits, which typically take the form of investments in countries with current account deficits

Carry trades [Principles]

- According to uncovered interest rate parity, carry trades should not produce excess returns because the interest rates between the two currencies should be reflected in the exchange rate - Evidence indicates excess returns to this strategy, which may be attributable to the riskiness of the high interest rate currencies (highly leveraged position)

Relative PPP [continued]

- Because there is no true arbitrage available to force relative PPP to hold, violations of relative PPP in the short run are common - However, because the evidence suggests that the relative form of PPP holds approximately in the long run, it remains a useful method for estimating the relationship between exchange rates and inflation rates

Flows in the BOP accounts effect on currency exchange rates

- Changes in the exchange rate are a mechanism for the balancing of the current account (the flows of the real economy) and the capital account (financial flows) - The dominant factor in explaining exchange rate movements are investment/financing decisions (capital account)

Effectiveness of capital controls

- The effectiveness of central bank intervention is mixed - Capital controls, if used inappropriately, can exacerbate a situation (e.g., use when not needed, circumvention of controls by market participants, spillover to other countries) - The evidence is mixed, but in general, capital controls do not reduce capital inflows

Estimating long-run fair value of an exchange rate

- The long-run fair value of a currency is most commonly assessed using relative PPP - The IMF suggests three different complementary approaches to estimating long-run fair value of an exchange rate: (1) Macroeconomic balance approach (2) External sustainability approach (3) Reduced-form econometric model approach

Flows in the BOP accounts effect on currency exchange rates [Other mechanisms]

- The price of real goods and services adjust more slowly than exchange rates and asset prices - Production of goods and services takes time, and demand decisions are subject to inertia

Time of day [Interbank spreads]

- The time overlap during the trading day when both the New York and London currency markets are open is considered the most liquid time window - Spreads are narrower during this period than at other times of the day

Balance of payments accounting (BOP)

current account + financial account + official reserve account = 0

Interbank spreads

depend on the currencies involved, time of day, and volatility in the currency pair

Reduced form econometric model

estimates the equilibrium real exchange rate for the currency based on key medium-term macroeconomic variables (e.g., net foreign asset position, terms of trade)

Forward premium (discount) for base currency

forward price - spot price

Relative purchasing power parity (Relative PPP) [example]

if (over a 1-year period) Country A has a 6% inflation rate and Country B has a 4% inflation rate, then Country A's currency should depreciate by approximately 2% relative to Country B's currency over the period

Forward contract

is an agreement to exchange a specific amount of one currency for a specific amount of another currency on a future date specified in the forward agreement

Currency crisis

is an economic downturn that is the result of a depreciation of a country's currency and subsequent instability in exchange rates

Forward exchange rate

is for future delivery

Spot exchange rate

is for immediate delivery

Triangular arbitrage

is taking advantage of incorrect exchange rates and such actions ensure that cross-rates are consistent

Spot exchange rate

is the currency exchange rate for immediate delivery, which for most currencies means the exchange of currencies takes place two days after the trade

Bid price

is the price at which the counterparty is willing to buy one unit of the base currency

Offer price

is the price at which the counterparty is willing to sell one unit of the base currency

Value of a forward contract at initiation

is zero to both parties

Relative purchasing power parity (Relative PPP)

states that the change in exchange rates between two countries' currencies is determined by the difference between foreign and domestic inflation rates

Absolute purchasing power parity (Absolute PPP)

states that the spot exchange rate between two countries is determined solely by the ratio of their national price levels (Pf,/Pd)

Pips

- Spreads are in terms of pips - A quote of 1.5400/1.5423 has a spread of 1.5423-1.5400 = 23 pips

Flows in the BOP accounts effect on currency exchange rates [Other mechanisms]

- Investment/financing decisions reflect the reallocation of existing portfolios in addition to current expenditures - Expected exchange rate changes can induce large short-term capital flows

Relationships among the international parity conditions

- Covered interest rate parity links forward discounts to the difference between foreign and domestic interest rates, whereas the international Fisher effect links the difference between foreign and domestic interest rates to differences in expected inflation - Ex ante purchasing power parity links the expected spot rates to the difference in expected inflation rates - The concept that a forward rate is an unbiased predictor of future spot rates links the expected change in spot rates to the forward discount or premium - Uncovered interest rate parity links the difference between the foreign and domestic interest rates to the expected change in spot exchange rates

External sustainability approach

- Estimates how much current exchange rates must adjust to force a country's external debt (asset) relative to GDP towards its sustainable level - estimates how much exchange rates would need to adjust to equate the country's ratio of net foreign asset to GDP or its ratio of net foreign liability to GDP to some benchmark level (that is, to stabilize), given a medium-term growth rate

Effects of fiscal policies on exchange rates

- Expansionary fiscal policy results in an increase in interest rates, which attracts capital and increases the value of the currency - Contractionary fiscal policy has the opposite effect

Effects of monetary policies on exchange rates

- Expansionary monetary policy results in an increase in the supply of the currency and, therefore, a depreciation in the currency - Contractionary monetary policy has the opposite effect

Effectiveness of FX market intervention [continued]

- For developed markets, the central bank resources on a relative basis are too insignificant to be effective at managing exchange rates - However, some emerging market countries with large FX reserves relative to trading volume have been somewhat effective - More persistent and larger capital flows are harder for central banks to manage using capital controls

Use of technical analysis in forecasting exchange rates

- Fundamentals-based forecasting models can explain long-term trends but are not useful for short-term trends in exchange rate movements - In previous decades, technical analysis using trend-based models had some ability to predict exchange rate movements, but more recently, these models perform poorly

Risks of the carry trade

- Funding currency may appreciate significantly against the currency of the investment, which would reduce a trader's profit—or even lead to a loss - Furthermore, the return distribution of the carry trade is not normal; it is characterized by negative skewness and excess kurtosis (i.e., fat tails), meaning that the probability of a large loss is higher than the probability implied under a normal distribution - We call this high probability of a large loss the crash risk of the carry trade

Forecasting future spot rates

- Future spot rates can be forecasted using PPP or by uncovered interest rate parity - However, neither relationship is bound by arbitrage, nor do these relationships necessarily work in the short term

Market volatility [Interbank spreads]

- Higher volatility leads to higher spreads to compensate market traders for the increased risk of holding those currencies - Spreads change over time in response to volatility changes

Flow supply/demand channel

- If a country exports more than it imports, demand for its currency increases, resulting in currency appreciation - Current account deficits in a country increase the supply of that currency in the markets (as exporters to that country convert their revenues to their own local currency). This puts downward pressure on the exchange value of that currency

Unbiased predictor

- If the forward rate is equal to the expected future spot rate, we say that the forward rate is an unbiased predictor of the future spot rate - In this special case, if covered interest parity holds (and it will; by arbitrage) uncovered interest parity would also hold (and vice versa) - Stated differently, if uncovered interest rate parity holds, the forward rate is an unbiased predictor of expected future spot rates

Forward and future spot rate

- If uncovered interest parity holds, then the forward rate will be equal to the future spot rate, and we say that the forward rate is an unbiased estimate of the future spot rate - But forward rates are poor predictors of future spot exchange rates because uncovered interest rate parity is often violated

Price currency transaction between investor and dealer [Further explained]

- If we need to buy USD (i.e., the price currency) using AUD (i.e., selling the base currency), we now use the dealer bid quote - Similarly, to sell the price currency, we use the dealer ask quote - So the rule is buy the price currency at bid and sell the price currency at ask

Base currency transaction between investor and dealer [Further explained]

- Imagine that you are given a USD/AUD bid and ask quote of 1.0508-1.0510 - Investors can buy AUD (i.e., the base currency) from the dealer at the ask price of USD 1.0510 - Similarly, investors can sell AUD to the dealer at the bid price of USD 1.0508 - Remember, investors always take a loss due to spread

Effectiveness of FX market intervention

- In developed countries, the FX market is so large that central bank actions are too small to be effective - Intervention lowers foreign exchange volatility in emerging markets but does not appear to affect exchange rates

Mundell-Fleming model [Principles]

- In this model, if exchange rates are flexible, expansionary monetary policy will increase net exports and expansionary fiscal policy may affect currency appreciation or depreciation - If exchange rates are fixed, expansionary monetary policy will increase interest rates, whereas expansionary fiscal policy will expand the money supply

Forward spreads

- Increase with maturities - Longer maturity contracts tend to be less liquid - Counterparty credit risk in forward contracts increases with maturity - Interest rate risk in forward contracts increases with maturity

Relationships among the various parity conditions 2

- Interest rate differentials should mirror inflation differentials. This holds true if the international Fisher relation holds - If that is true, we can also use inflation differentials to forecast future exchange rates—which is the premise of the ex-ante version of PPP

Mark-to-market value of a forward contract [continued]

- To calculate the mark-to-market value of a forward contract, we begin with the original position and then determine the price of an offsetting position - The offsetting position is the opposite side of the transaction (e.g., if originally sold forward, then the opposite position is to buy forward), with the same time remaining - The profit or loss is the difference between the present value of the difference in the forward price of the original position and that of the offsetting position

Pure monetary model

- Under a pure monetary model, the PPP holds at any point in time and output is held constant - An expansionary (restrictive) monetary or fiscal policy leads to an increase (decrease) in prices and a decrease (increase) in the value of the domestic currency - The pure monetary approach does not take into account expectations about future monetary expansion or contraction

Monetary approach

- Under monetary models, we assume that output is fixed and, hence, monetary policies primarily affect inflation, which in turn affects exchange rates - is based on the idea that the relative price of currencies is a function of the relative supply of and demand for the currencies - With flexible exchange rates, a change in the money supply will cause a change in equilibrium and the nominal exchange rates (and hence, cause a change in exchange rates) - An increase in the money supply increases price levels and results in a depreciation in the currency

Effects of both monetary and fiscal policies on exchange rates

- When both the monetary and fiscal policy are expansionary, the effect on exchange rates is not clear - When both the monetary and fiscal policy are restrictive, the effect on exchange rates is not clear

Use of technical analysis in forecasting exchange rates [continued]

- Wide swings in exchange rates are less common, so it is less probable that a technical analyst can earn excess returns - Some excess returns in FX in emerging markets are possible because excess profits have not yet been arbitraged away or because these currencies have appreciated over time - Other market indicators are order flow, sentiment, and positioning

Quote interpretation

- a quote is the price of one unit of the base currency in terms of the price currency - The bid and offer (also known as ask) price are in terms of the price currency

Dornbusch overshooting model [continued]

- according to the model, in the short term, exchange rates overshoot the long-run PPP implied values - In other words, under an expansionary monetary policy, in the short term, the depreciation of currency is greater than the depreciation implied by PPP - In the long term, exchange rates gradually increase toward their PPP implied values

Official reserve account

- are transactions made from the reserves held by the official monetary authorities of the country - Normally the official reserve account balance does not change significantly from year to year, and hence, economists focus on the first two parts of the BOP equation

Absolute purchasing power parity (Absolute PPP)

- compares the average price of a representative basket of consumption goods between countries - requires only that the law of one price be correct on average, that is, for like baskets of goods in each country - In practice, even if the law of one price held for every good in two economies, absolute PPP might not hold because the weights (consumption patterns) of the various goods in the two economies may not be the same (e.g., people eat more potatoes in Russia and more rice in Japan)

Covered vs uncovered interest rate parity

- covered interest rate parity derives the no-arbitrage forward rate, while uncovered interest rate parity derives the expected future spot rate (which is not market traded) - Covered interest parity is assumed by arbitrage, but this is not the case for uncovered interest rate parity

Asset market (Portolio balance) model

- focuses on the long-term implications of sustained fiscal policy (deficit or surplus) on currency values - assumes that investors hold diversified portfolios of stocks and bonds, domestic and foreign - Persistent deficits will cause rebalancing of portfolios away from the country and an eventual depreciation of the currency - When a country runs sustained deficits, investors require higher returns, which leads to higher interest rates and/or the depreciation of the currency

Objectives of central bank intervention and capital controls

- goal of intervention is to prevent or mitigate surges in capital flows that may result in currency crises or other economic problems - ensures that the domestic currency does not appreciate excessively - Allows the pursuit of independent monetary policies without being hindered by their impact on currency values - Reduces excessive inflow of foreign capital

Covered interest rate parity [continued]

- holds when any forward premium or discount exactly offsets differences in interest rates, so that an investor would earn the same return investing in either currency - If covered interest rate parity holds and euro interest rates are higher than dollar interest rates, depreciation of the euro relative to the dollar will just offset the higher euro interest rate - arbitrage will force the forward contract exchange rate to a level consistent with the difference between the two country's nominal interest rates

Forward exchange rate

- is a currency exchange rate for an exchange to be done in the future - Forward rates are quoted for various future dates (e.g., 30 days, 60 days, 90 days, or one year)

Balance of payments accounting (BOP) [Definition]

- is a method used to keep track of transactions between a country and its international trading partners - Includes government transactions, consumer transactions, and business transactions - BOP accounts reflect all payments and liabilities to foreigners as well as all payments and obligations received from foreigners - When a country experiences a current account deficit, it must generate a surplus in its capital account

Mundell-Fleming model

- is a model of a small but open economy and describes the relationship between the exchange rate, interest rates, and GDP - evaluates the impact of monetary and fiscal policies on interest rates—and consequently on exchange rates - Changes in inflation rates due to changes in monetary or fiscal policy are not explicitly modeled by the Mundell-Fleming model - we assume that inflation (price levels) play no role in exchange rate determination - focuses on the short-term implications of fiscal policy and, as such, is inadequate

FX Carry Trade

- seeks to profit from the failure of uncovered interest rate parity to work in the short run - is a strategy in which there is a long position in high-yielding currencies (that is, countries with higher interest rates) and short positions in low-yielding currencies (that is, countries with lower interest rates, referred to as funding currencies) - an investor invests in a higher yielding currency using funds borrowed in a lower yielding currency. The lower yielding currency is called the funding currency

Relative purchasing power parity (Relative PPP)

- states that changes in exchange rates should exactly offset the price effects of any inflation differential between the two countries - is based on the idea that even if absolute PPP does not hold, there may still be a relationship between changes in the exchange rate and differences between the inflation rates of the two countries

International Fisher effect

- tells us that the difference between two countries' nominal interest rates should be equal to the difference between their expected inflation rates - is based on the idea that with free capital flows, funds will move to the country with a higher real rate until real rates are equalized

Mark-to-market value of a forward contract

- value of a forward currency contract prior to expiration - reflects the profit that would be realized by closing out the position at current market prices, which is equivalent to offsetting the contract with an equal and opposite forward position

Combining the Mundell-Fleming and portfolio balance approaches

- we find that in the short term, an expansionary (restrictive) fiscal policy leads to domestic currency appreciation (depreciation) - In the long term, the impact on currency values is opposite

1 Pip is ...

1/10,000

Covered interest rate parity [Assumptions]

It assumes transaction costs are zero and that the money market instruments are similar with respect to liquidity, maturity, and default risk

Transaction size

Larger, liquidity-demanding transactions generally get quoted a larger spread

Relationship between dealer and client

Sometimes dealers will give favorable rates to preferred clients based on other ongoing business relationships


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