Economics #13 - Currency Exchange Rates: Determination and Forecasting

Question 1

Spot Exchange Rate (def)

Forward Exchange Rate (def)

Answer 1

LOS 13.a

spot exchange rate - currency exchange rate for immediate delivery

forward exchange rate - currenct exchange rate to be done in the future

Question 2

exchange rate (def)

Answer 2

LOS 13.a

exchange rate - the price of one currency in terms of another currency.

e.g. 1.4126USD/EUR

“each Euro costs $1.4126 USD”

numerator is the Price currency e.g. USD

demoninator is the Base currency e.g EUR

Question 3

currency exchange spread (def)

Answer 3

LOS 13.a

The difference between the ask (offer) price and bid price

e.g. AUD/GBP: 1.5060 - 1.5067

AUD/GBP bid = 1.5060 AUD

AUD/GBP ask = 1.5067 AUD

Question 4

what is a “pip”?

Answer 4

LOS 13.a

pip - 1/10,000 of the price currency

Question 5

The spread quoted by a dealer depends on…

Answer 5

LOS 13.a

1. spread in the interbank market for the same currency pair
2. size of the transaction - larger transactions usually get quoted a larger spread (due to liquidity demands)
3. relationship between dealer and client - favorable clients can get better rates.

Question 6

The interbank spead on a currency pair depends on…

Answer 6

LOS 13.a

1. currencies involved - high-volume pairs (e.g. USD/EUR, JPN/USD, USD/GBP) command lower spreads than lower volume pairs (e.g. AUD/CAD)
2. time of day - time overlap of US and Europe is consider the most liquid time window and when spreads are narrower
3. market volatility - higher volatility commands wider spreads.

Question 7

Why do foward spreads tend to wider with longer maturies?

Answer 7

LOS 13.a

these increase with longer maturities:

illiquidity

counterparty credit risk

interest rate risk

Question 8

Describe currency exchange pricing wrt investors and dealers

Answer 8

LOS 13.b

investors always take a loss and dealers always make a profit

For transactions in base currency (denominator):

investors buy/dealers sell at the ask price

investors sell/dealers buy at the bid price

buy the base currency at ask and sell base currency at bid.

For transactions in price currency (numerator):

investors buy/dealers sell at the ask price

investors sell/dealers buy at the bid price

buy the price currency at bid and sell price currency at ask.

Question 9

What is the rule to follow (as investor) with exchange quotes?

Answer 9

LOS 13.b

• “up the bid and multiply;*
• down the ask and divide.”*

Question 10

Rules for cross rate conversions

Answer 10

LOS 13.b

(A/C)_bid = (A/B)_bid * (B/C)_bid

(A/C)ask = (A/B)ask * (B/C)ask

(B/C)_bid = 1 / (C/B)ask

(B/C)ask = 1 / (C/B)bid

Question 11

Demonstrate triangular arbitrage

Answer 11

LOS 13.b

(be able to reproduce one of the problems in the study guide)

My rules for setup:

put common currency at top of triangle

dealer quote goes across the bottom

go clockwise, then counterclockwise

Question 12

Compute the forward premium of the base currency from spot and forward quotes

Answer 12

LOS 13.c

The forward premium (discount) for base currency B is:

forward premium (discount) = F_t - S₀, where

F_t = forward quote t days in the future

S₀ = spot quote

When forward rates are quotes in pips (i.e. +/- p):

forward premium (discount) = F_t +/- p/10,000

Question 13

Compute value of a future contract at maturity

Answer 13

LOS 13.c

For party buying the base currency at maturity (time T):

V_T = (FP_T - FP) * (contract size), where

V_{<span>T</span>} = value of forward contract at time T (denominated in price currency)

T = maturity of forward contract

FP = forward price locked in at inception to buy base currency maturing at time T

FP_T = forward price to sell same currency at time T

contract size = number of currency units covered by the agreement

Question 14

Compute mark-to-market value of a future contract

Answer 14

LOS 13.d

For party buying the base currency at maturity (time T), the mark-to-market value of the contract at time t (t<t></t>

<p><strong>V_t = (FP_t - FP) * (contract size) / (1+R(days/360))</strong>, where</p>

<p><span>V_t = value of forward contract at time t (denominated in <u>price </u>currency)</span></p>

<p><span>FP_t = forward price (to <u>sell base</u> currency) at time t in the market for a new contract maturing at time T</span></p>

<p><span>FP = forward price specified in original contract (to <u>buy base</u> currency)</span></p>

<p><span>days = days remaining to maturity of original contract (T - t)</span></p>

<p><span>R = interest rate of <u>price </u>currency (T-t days rate)</span></p>

<p><span>contract size = number of currency units covered by the agreement</span></p>

</t>

Question 15

What is covered interest rate parity? (def)

Answer 15

LOS 13.e

covered interest rate parity - the condition when any forward premium or discount exactly offsets differences in interest rates such thgat an investor would earn the same return investing in either currency.

The term “covered” means to be “bound by arbitrage.

Question 16

formula definition of interest rate parity

Answer 16

LOS 13.d

Given A/B quote structure:

F = S₀ * (1 + R_A (days/360)) / (1 + R_B (days/360)), where

F = forward rate (quoted as A/B)

S₀ = spot rate (quoted as A/B)

days = number of days in the underlying forward contract

R_A = interest rate for currency A

R_B = interest rate for currency B

Question 17

relative purchasing power parity (PPP)

Answer 17

LOS 13.e

• changes in exchange rates will perfectly offset changes in price levels i.e. d(inflation)
• ex-ante: E(%d(S)_A/B = E(π_A) - E(π_A/B)
• countries with higher (relative) inflation expect to see their currency depreciate (by the inflation differential)

Question 18

International Fisher Relation (IFR)

Answer 18

LOS 13.e

• Domestic Fisher Relation: R = r + E(π)
  R = nominal interest rate; r = real interest rate, π = inflation
• International Fisher Relation:
  assuming interest rates are constant (real rate parity):
  R_A - R_B = E(π_A) - E(π_B)
  (i.e. interest rate differential = inflation differential)

Question 19

uncovered interest rate parity (unCIRP)

Answer 19

LOS 13.e

• relative form PPP + IFR = uncovered interest rate parity
• links spot exchange rates and nominal interest rates

E(%dS)_A/B = R_A - R_B

• unCIRP relies on both the IFR and rel PPP holding over time

Question 20

International Parity Relationships

Answer 20

LOS 13.f,g

Forward prem/disc ⇔ Fwd rate unbiased ⇔ E(FX rate) expectations
^ predict of future S rates / /movements
| / ^
CIRP unCIRP |
| / rel PPP
| / |
v v
d(int rates) ⇔ ⇔ ⇔ ⇔ ⇔ IFR ⇔ ⇔ ⇔ d(inflation)

Question 21

Taylor Rule

Answer 21

LOS 13.j,l

• Taylor Rule - Central Bank policy rate determination
• “the real interest rate (hence currency value) is positively related to inflation and output”

RT = r_n + π + a(π - π*) + ß(y - y*)

R = central bank policy rate implied by Taylor Rule

r_n = neutral real policy interest rate

π and π* = current and target inflation rate

y and y* = log of current and target output (GDP)

a and ß = policy response coeffients

Question 22

objectives of the central bank intervention

Answer 22

LOS 13.n

objectives of capital controls or central bank intervention in FX markets are to:

• ensure DC does not appreciate excessively
• allow pursuit of independent monetary policies without being hindered by their impact on currency values
• reduce excessive inflow of foreign capital

Question 23

central bank effectiveness of intervention and capital controls

Answer 23

LOS 13.n

• developed countries: its currency trade volume is high wrt FX reserves of its central bank, so intervention in FX markets due to insufficient resources
• EM countries:
  
  • if FX reserves are sufficient relative to trading volume, could be effective
  • empirically: large, persistent capital flows are harder for EM central banks to mitigate

Question 24

warning signs of a capital crisis

Answer 24

LOS 13.o

according to the IMF, warning signs of a capital crisis:

• terms of trade deteriorate
• offical foreign exchange reserves dramatically decline
• real exchange rate is substantially higher than the mean-reverting level
• inflation increases
• equity markets experience a boom-bust cyclemoney supply relative to bank reserves increases
• nominal private credit grows

Question 25

technical analysis in forecasting exchange rates

Answer 25

LOS 13.p

• trend-following trading rules - e.g. moving average crossover, also combining with FX carry trade strategies
• FX dealer order books - strong positive contemporaneously (non-lagged) correlation observed between order flow and currency value
• currency options markets - implied volatility from FX options give insights to currency movements e.g. if implied volatility in a call option > implied volatility of its put option ⇒ market expects currency to appreciate.

Question 26

real exchange rate

Answer 26

LOS 13.g

the real exchange rate between a currency pair includes an adjustment for inflation differentials between the two countries since a base year:

real exch. rate = S_t(CPI_B / CPI_A),
S_t = spot rate (A/B) at time t

Question 27

balance of payments (BOP)

Answer 27

LOS 13.j

current acct + fin’l acct + official reserv. acct = 0

• current account - measuers exchange of goods, services, investment income, and unilateral transfers (gifts to/from nations)
• financial account (aka capital account) - measures flow of funds for debt and equity investment in/out of the country
• official reserve account - acct with reserves

Question 28

problems for EMs with excessive capital inflows

Answer 28

LOS 13.j

• excessive real appreciation of the DC
• financial asset and/or real estate bubbles
• increases in external debt by businesses or government
• execssive consumption in the domestic market fueled by credit

EM govt counteract excessive inflows by:

• imposing capital controls
• direct intervention in FX markets