Class 8 Flashcards
Name the 3 determinant of exchange rate
1) Parity conditions approach
2) Balance of payments
3) Monetary Approach and asset market approach
Of the 3 determinants of exchange rate, which is the most relative or used? What does this mean?
Relative purchasing power parity
This means that changes in relative prices (considering inflation) between countries drive the change in exchange rates over time
Has PPP proven to be accurate for exchange rates in the short term? Why?
Not it hasn’t proven to be good in the short term since its basic assumption is that the only thing that matters is relative price changes which isn’t true since many currencies are driven by supply and demand
What is the second most used approach to exchange rates? Why?
Balance of Payment because it takes into account supply and demand and current and financial account of a country
In BOP exchange rate, how do you know when the equilibrium exchange rate is found
When the inflow of foreign exchange from current accounts matches net outflow of foreign exchange coming from financial account activities
What is a criticism of the BOP approach
It emphasis on flow of currency an capital rather than on stocks of money and financial assets
Who hates and who used the BOP approach for FX
Hated by academic community but used by market participants
What is the monetary approach to FX
exchange rate is determined by supply and demand of national monetary stocks and the expected futures levels and rates of growth of monetary policy
Are other financial assets useful in monetary approach FX? Why?
No, because both domestic and foreign bonds are viewed as perfect substitiues
What is used in the monetary approach to determine inflation?
Supply and demand for money
What is a weakness of monetary models
That real economic activity is relegated to a role in which it only influences exchange rates through changes in the demand for money
What is the asset market approach
States that the supply and demand for many financial assets determines the exchanger rates
What impacts does the supply and demand of financial assets have?
Has an impact on exchange rates since it alters expected returns and perceived risks of financial asstes
When are the foreign exchange rate theories most useable
in the short to medium term, but not in the long term
How may a currency be valued by an investor?
Similar to a bond or stock, based on the expected future events and flows of cross-border funds
What is currency market intervention?
When the government steps in and plays with the market’s valuation of a currency
What are the 3 intervention methods?
Direct intervention
In-direct intervention
Capital control
What is direct intervention?
Central bank buys or sells its own currency in the foreign exchange market to influence the exchange rate
What is indirect intervention
Shape value through economic policies and signals which could be interest rates, economic forecasts or announcements
How does increasing interest rates make a currency more attractive?
Because it makes the investments more attractive, which increases demand
What is capital control
Limit the ability to exchange domestic currency for foreign currency which means more trading takes place
What is an institutional investor? How do they have an impact on the market
An investor that invests large sums on behalf of others. Since they are so big and make such big trades there create movements in the market
Do institutional investors have a long term or short term length of investments? Why?
Long term since they are often done for pensions or insurances
Why do institutional investors invest in foreign markers
Because they are so big in terms of capital they are “forced” to invest foreignly
How is there agency problems in these institutional investors
The investors get paid on medium to short term basis but the investments are supposed to be made for long term. As well, the investors get bonuses based on investment performance which may be a short term spike in investements
How is hedging for institutional investors?
Imperfect because of their large value and its fluctuation therefore it is hard to predict how much to hedge for
What is fair value hedging
It is a type of hedging that is particular to institutional investors where hedging can be done on the whole amount invested, the expected future yield as well as the expected future value of the investment
When can institutional investors hedge all of their investments with long term investments
When currencies involved are stable and have liquid long-term FX derivative markets
If you’re a canadian pension fund and want to make decision to invest or not in the US, how do you weigh that investment versus making an investment in Thailand
-Look at the ability to hedge either investment
-Since you are a pension fund, look at time horizon of investments
