Chapter 4 Flashcards
Percentage change in currency value
(S - St-1 )/ St-1
Positive = appreciate
Negative = depreciate
Demand for Currency
increases when the value of the currency decreases, leading to a downward sloping demand schedule.
Supply of Currency
increases when the value of the currency increases, leading to an upward sloping supply schedule.
Factors that Influence Exchange Rates ***
Inflation
Interest rate
Income
Government Controls
Expectations of future rates
Impact of higher US Inflation on Equilibrium for foreign value
US Increase foreign currency demand (demand out)
Lower foreign demand for US currency (supply in)
Increase in exchange rate
Impact of Higher US Interest Rates on Equilibrium for foreign value
Foreign want US = More supply sale of foreign = supply shift outward
Less demand for foreign = inward shift demand
Decrease exchange rate
Real interest rate **
nominal rate - inflation rate
aka fisher effect
Impact of Higher US Income Levels on Equilibrium for foreign value
Spend more = more foreign demand = shift outward
Higher exchange rate USD/Foreign
Methods of Government Controls
imposing foreign exchange barriers;
imposing foreign trade barriers;
intervening (buying and selling currencies) in the foreign exchange markets; and
affecting macro variables such as inflation, interest rates, and income levels.
Impact of Expectation on Rates
Favorable: invest in the country = more demand for currency = increase rate
Unfavorable: downward pressure
Signals: may overreact -> temp overvalued or undervalued
Impact of a Currency Crisis
How does liquidity impact rate changes
Liquid market = not sensitive = change small
Illiquid market = highly sensitive = change more volatile
Movements in Cross Exchange Rates
a. move same
b. A appreciate more than B
c. A appreciate, B remain same
A and B move in same direction = no change in cross rate
Currency A appreciates vs dollar
more > than Currency B appreciates = A appreciates vs B
OR
A appreciate less than B appreciate = A depreciates vs B
Currency A appreciates vs dollar, Currency B remains same = Currency A appreciates vs Currency B (same amount as appreciate vs dollar)
OR
Currency A depreciates vs dollar, Currency B remained same = Currency A depreciates vs Currency B (same amount as depreciate vs dollar)
Speculate based on expected appreciation (undervalue) **
Invest now before appreciate, liquidate after appreciate (sell higher than buy)
Speculate based on expected depreciation (overvalue) **
Borrow funds of foreign (overvalued) currency and convert to local currency now, invest local now
Wait till deppreciet, Convert (foreign) later at lower (rcvd more than start) to repay loan (profit)
What is a carry trade? (practice) Risks?
Where investors attempt to capitalize on the differential
in interest rates between two countries
Borrow at lower rate, and invest in currency w higher rates
Can move at opposite way than expected
Impact of appreciation on carry trade
if British pound (invest in) appreciated against euro (borrow) & USD (borrow) = profits higher
Pound (invest) appreciate vs euro (borrow) -> Each pound = more euros (Step 6)
Need less pounds to repay euro loan
Pound appreciate vs dollar -> remaining pounds after loan repaid = more dollar (step 8)
Downward pressure on currency being converted (sold) and upward on currency purchased
Carry Trade Profit:
Earn 1% of funds invested in pounds
Pay 0.5% on euros borrowed
$1.8 (per) pound spot rate
1 pound = 1.5 euros
invest 100,000 USD , 600,000 euros borrowed, invest in pounds
Profit 4598
Carry Trade Profit:
Earn 1% of funds invested in pounds
Pay 0.5% on euros borrowed
1.8 pound spot rate
1 pound = 1.456 euros
invest 100,000 USD , 600,000 euros borrowed, invest in pounds
Loss: -17268
