CFA 2 - Econ - Reading 13: Currency Exchange Rates: Determination and Forecasting

4.13.k Zimbaya's current policy rate is 3% while its neutral real rate is 2%. Inflation is currently muted at 2% while the target inflation rate is 3%. The current GDP growth rate is 3% while the target is for 2.5% GDP growth. Zimbaya's central bank follows the Taylor rule in setting policy rates and uses policy parameters α = β = 0.5. What is the most likely course of action by Zimbaya's central bank with regard to the policy rate?

A: Increase the rate by 0.75%. policy rate = neutral real rate + inflation + 0.5(inflation gap) + 0.5(output gap) = 2% + 2% + 0.5(2% - 3%) + 0.5(3% - 2.5%) = 3.75% This represents an increase of the policy rate by 0.75% over the current level of 3%. The Mundell-Fleming model of exchange rate determination evaluates the impact of monetary and fiscal policies on interest rates and consequently on exchange rates. Under monetary models, we assume that output is fixed and, hence, monetary policies primarily affect inflation, which in turn affects exchange rates. The portfolio balance (asset market) model evaluates the long-term implications of sustained fiscal policy (deficit or surplus) on currency values.

4.13.c The forward rate on a 90-day contract is FC/USD 5 and the spot is FC/USD 4. The USD is trading at a forward:

A: premium of 1.0. Base currency (USD in this case) is at a forward premium if the forward rate is above the spot rate. Forward premium = forward rate - spot rate = 5 − 4 = 1. A spot exchange rate is for immediate delivery, while a forward exchange rate is for future delivery. premium (discount) for base currency = forward price - spot price

4.13.f Ackerman explains to Bos that a theoretical relationship exists between forward rates and future spot rates, called the foreign exchange expectation relation. This relation suggests that:

A: the forward rate is an unbiased predictor of the expected future spot rate, and uncovered interest rate parity would hold. The foreign exchange expectation relation is F = E(S1), meaning that the forward rate is an unbiased predictor of the expected future spot rate. If this is the case, uncovered interest rate parity would be same as covered interest rate parity and since covered interest rate parity holds (by arbitrage), uncovered interest rate parity would also hold.

4.13.o Which of the following is least likely a warning sign of an impending currency crisis?

A: Money supply relative to bank reserves shrinks. Warning sign of an impending currency crisis is when money supply relative to bank reserves grows (not shrinks). Warning signs of currency crises include: deterioration in terms of trade, a dramatic decline in official foreign exchange reserves, a real exchange rate substantially higher than its mean-reverting level, increases in the inflation rate, a boom-bust cycle in equity markets, an increase in money supply relative to bank reserves, and growth of nominal private credit.

4.13.e For an investor pursuing a carry-trade, the funding currency would most likely be the: US Dollar ($) UK Pound (£) Euro (€) Expected inflation rate 6.0% 3.0% 7.0% One-year nominal interest rate 10.0% 6.0% 9.0%

A: Pound. Under a carry trade, the funding currency is the lower yielding currency (in this case, the pound with 1-year nominal interest rate of 6% is the best candidate).

4.13.e Which of the following is least likely to be a warning sign for currency crisis?

A: Real exchange rate substantially lower than mean reverting level. One of the warning signs of a currency crisis is that real exchange rate is substantially higher than the mean reverting level.

4.13.e The no-arbitrage one-year forward USD/EUR rate is closest to: US Dollar ($) UK Pound (£) Euro (€) Expected inflation rate 6.0% 3.0% 7.0% One-year nominal interest rate 10.0% 6.0% 9.0% Market Spot Rates US Dollar ($) UK Pound (£) Euro (€) US Dollar ($) $1.0000 $1.6000 $0.8000 UK Pound (£) 0.6250 1.0000 2.0000 Euro (€) 1.2500 0.5000 1.0000

A: USD/EUR 0.8073. Interest rate parity implies that, in order to prevent covered interest arbitrage, the one-year forward USD/EUR rate should be equal to $0.8000(1.10) / (1.09) = $0.8073.

4.13.m Under the Mundell-Fleming model and the asset market approach to exchange rate determination, a country following sustained expansionary fiscal policy would see its currency:

A: appreciate in the short-run and depreciate in the long-run. Under Mundell-Fleming model, a country running expansionary fiscal policy (i.e., running fiscal deficits) would attract foreign capital due to high interest rates and will see its currency appreciate in the short-run. Under the asset market approach, in the long-run sustained deficits will increase the risk of the country's debt and lead to a currency depreciation. 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. Taylor-rule-prescribed central bank policy rate = (neutral real policy rate) + (current inflation rate) + α(inflation gap) + β(output gap) = (neutral real policy rate) + (current inflation rate) + α(current inflation rate - target inflation rate) + β(log of the current level of output - log of the potential level of output)

4.13.f Terrance Burnhart, a junior analyst at Wertheim Investments Inc., was discussing the concepts of purchasing power parity (PPP) and uncovered interest rate parity (UIRP) with his colleague, Francis Ferngood. During the conversation Burnhart made the following statements: Statement 1: Absolute PPP is based on a number of unrealistic assumptions that limits its real-world usefulness. These assumptions are: that all goods and services can be transported among countries at no cost; and all countries use the same basket of goods and services to measure their price levels. Statement 2: UIRP rests on the idea of equal real interest rates across international borders. Real interest rate differentials would result in capital flows to the higher real interest rate country, equalizing the rates over time. Another way to say this is that differences in interest rates are equal to differences in expected changes in exchange rates. With respect to these statements:

A: both are correct. UIRP means that interest rates and exchange rates will adjust so the risk adjusted return on assets between any two countries and their associated currencies will be the same. PPP is based on the idea that a given basket of goods should cost the same in different countries after taking into account the changes in exchange rates. PPP does not hold due to transportation costs and other factors.

4.13.m Country P has high capital mobility and has recently switched from balanced fiscal policy to an expansionary fiscal policy. Over time this expansionary is expected to lead to an increase in government debt to GDP ratio. If we simultaneously consider both the Mundell-Fleming and the portfolio balance model, in the long run country P's currency is most likely to:

A: depreciate. Under the portfolio balance model, as the ratio of government debt to GDP increases over time and the level of government debt becomes unsustainable, the currency of country P should depreciate. (Under the Mundell-Fleming model, country P's currency should appreciate in the short-term as fiscal deficits push interest rates higher, however this question is specifically asking about the long-run effect).

4.13.e Assuming high capital mobility in the U.K. and the U.S., according to the Mundell Fleming model, the £/$ is most likely expected to: Nance receives a report from Jamshed Banaji, Chief Economist at Central City Bank providing broad U.K and U.S. macro-economic forecasts. Nance notes that the Bank of England is expected to pursue an expansionary monetary policy while the Federal Reserve monetary policy is expected to be neutral. Also, the British parliament is expected to reduce the budget deficits more aggressively as compared to the U.S.

A: increase. Relative to the U.S, the U.K. monetary policy is expected to be expansionary and fiscal policy is expected to be restrictive. Under the Mundell-Fleming framework (in the case of high capital mobility), the pound should depreciate and hence the £/$ rate should increase.

4.13.e Everything else held constant, if the output gap (i.e., current output - potential output) is higher in US than in UK, the real value of £/$ is most likely expected to:

A: increase. Under the Taylor rule, a higher output gap in U.S. would translate into higher real interest rates in US leading to appreciation of the USD (and hence higher pounds/dollar). An increase in the output gap in the euro area relative to the output gap in the United States should strengthen the euro versus the dollar in real terms. Covered interest arbitrage: F = (1 + Ra (Days/360)) / (1 + Rb (Days/360)) * S0 Uncovered interest rate parity: E(%ΔS)A/B = RA - RB International Fisher relation: RnomA - RnomB = E(InflationA) - E(InlfationB) Relative PPP: St = S0 ((1 + InflationA) / (1 + InflationB)) ^ t

4.13.e Assume borrowing and lending rates are equal and bid-ask spreads are zero in the spot and forward markets. Using the data above, Nance is asked to calculate the profits in pounds from covered interest arbitrage between the United Kingdom and the United States, assuming an investor starts by borrowing ₤500,000. The answer is: US Dollar ($) UK Pound (£) Euro (€) Expected inflation rate 6.0% 3.0% 7.0% One-year nominal interest rate 10.0% 6.0% 9.0% Market Spot Rates US Dollar ($) UK Pound (£) Euro (€) US Dollar ($) $1.0000 $1.6000 $0.8000 UK Pound (£) 0.6250 1.0000 2.0000 Euro (€) 1.2500 0.5000 1.0000 Market 1-year Forward Rates US Dollar ($) UK Pound (£) Euro (€) US Dollar ($) $1.0000 $1.6400 $0.8082 UK Pound (£) 0.6098 1.0000 2.0292 Euro (€) 1.2373 0.4928 1.0000

A: ₤6,585.37. In this example, covered interest arbitrage involves borrowing pounds at the U.K. interest rate, converting to dollars at the spot rate, investing the dollars at the U.S. interest rate, converting the dollar investment proceeds back to pounds at the forward rate, and repaying the pound loan. Arbitrage profits are the difference between the proceeds from the forward contract and the amount repaid on the loan. We start by borrowing 500,000. At a borrowing rate of 6.0%, we will have to repay 500,000(1.06) = 530,000 at the end of the year. We convert the 500,000 pounds to dollars at the spot rate of $1.6000, which gives us 500,000 × 1.6000 = $800,000. We invest $800,000 for one year at 10.0%, and at the end of the year we receive $800,000(1.10) = $880,000. This means that initially we must enter into a forward contract at $1.6400 and then at the end of the year convert $880,000 into ($880,000 / $1.6400) = 536,585.37. We pay back the 530,000 loan balance and our arbitrage profits are 536,585.37 − 530,000 = 6,585.37.