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Copied Decks > Economics #13 - Currency Exchange Rates: Determination and Forecasting > Flashcards

Economics #13 - Currency Exchange Rates: Determination and Forecasting Flashcards

1
Q

Spot Exchange Rate (def)

Forward Exchange Rate (def)

A

LOS 13.a

spot exchange rate - currency exchange rate for immediate delivery

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

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2
Q

exchange rate (def)

A

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

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3
Q

currency exchange spread (def)

A

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

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4
Q

what is a “pip”?

A

LOS 13.a

pip - 1/10,000 of the price currency

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5
Q

The spread quoted by a dealer depends on…

A

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.
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6
Q

The interbank spead on a currency pair depends on…

A

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.
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7
Q

Why do foward spreads tend to wider with longer maturies?

A

LOS 13.a

these increase with longer maturities:

illiquidity

counterparty credit risk

interest rate risk

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8
Q

Describe currency exchange pricing wrt investors and dealers

A

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.

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9
Q

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

A

LOS 13.b

  • “up the bid and multiply;*
  • down the ask and divide.”*
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10
Q

Rules for cross rate conversions

A

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

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11
Q

Demonstrate triangular arbitrage

A

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

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12
Q

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

A

LOS 13.c

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

forward premium (discount) = Ft - S0, where

Ft = forward quote t days in the future

S0 = spot quote

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

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

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13
Q

Compute value of a future contract at maturity

A

LOS 13.c

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

VT = (FPT - 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

FPT = forward price to sell same currency at time T

contract size = number of currency units covered by the agreement

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14
Q

Compute mark-to-market value of a future contract

A

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

Vt = (FPt - FP) * (contract size) / (1+R(days/360)), where

Vt = value of forward contract at time t (denominated in price currency)

FPt = forward price (to sell base currency) at time t in the market for a new contract maturing at time T

FP = forward price specified in original contract (to buy base currency)

days = days remaining to maturity of original contract (T - t)

R = interest rate of price currency (T-t days rate)

contract size = number of currency units covered by the agreement

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15
Q

What is covered interest rate parity? (def)

A

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.

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16
Q

formula definition of interest rate parity

A

LOS 13.d

Given A/B quote structure:

F = S0 * (1 + RA (days/360)) / (1 + RB (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

RA = interest rate for currency A

RB = interest rate for currency B

17
Q

relative purchasing power parity (PPP)

A

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(πA) - E(πA/B)
  • countries with higher (relative) inflation expect to see their currency depreciate (by the inflation differential)
18
Q

International Fisher Relation (IFR)

A

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):
    RA - RB = E(πA) - E(πB)
    (i.e. interest rate differential = inflation differential)
19
Q

uncovered interest rate parity (unCIRP)

A

LOS 13.e

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

E(%dS)A/B = RA - RB

  • unCIRP relies on both the IFR and rel PPP holding over time
20
Q

International Parity Relationships

A

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)

21
Q

Taylor Rule

A

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 = rn + π + a(π - π*) + ß(y - y*)

R = central bank policy rate implied by Taylor Rule

rn = 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

22
Q

objectives of the central bank intervention

central bank effectiveness of intervention and capital controls

warning signs of a capital crisis (according to IMF):

A

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

central bank effectiveness of intervention and capital controls

  • 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

warning signs of a capital crisis (according to IMF):

  • 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
23
Q

technical analysis in forecasting exchange rates

A

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.
24
Q

real exchange rate

A

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 = St(CPIB / CPIA),
St = spot rate (A/B) at time t

25
Q

balance of payments (BOP)

A

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
26
Q

problems for EMs with excessive capital inflows

A

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

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