Economics - Chp. 13: Currency Exchange

Question 1

Bid definition

Answer 1

• Price at which dealer will buy “Base” currency

Question 2

Offer ( or “ask”)

Answer 2

– Price at which dealer will sell “base”

Question 3

Spread

Answer 3

• Difference b/t bid and offer, spread of $.0004 is “4 pips”, depends on:
  
  • Spread of the interbank markets
  • Size of transaction (larger transaction -> larger spread)
  • Relationship of dealer and client

Question 4

Interbank spread depends on

Answer 4

• Currencies involved
• Time of day
• Market volatility: spreads related to volatility of currencies involved
• Spreads increase with longer contracts (more risk)

Question 5

Rule for multiplication/division and using bid/ask

Answer 5

• “Up the bid and multiply, down the ask and divide”
  
  • For USD/AUS
    
    • Going from usd ->aus, use the ask
    • Going from aus->usd, use the bid

Question 6

• Cross rate with Bid-Ask spread rule 1 (cross rate)

Answer 6

Question 7

Cross rate with Bid-Ask spread rule 2 (two currency)

Answer 7

Question 8

Triangular Arbitrage:

Answer 8

• Use three currecies, each with their bid and ask quotes
  
  1. Go around triangle clockwise and see if the quotes are the same when you get back to the beginning
  2. “Up the bid and multiply, down the ask and divide”

Question 9

1. Forward Premium or discount if for the Base currency

Answer 9

Question 10

• Mark to market value – Value of forward currency contract

Answer 10

Question 11

Covered interest rate parity

Answer 11

Forward premium or discount exactly offsets difference in interest rates, so return for both currencies the same

Question 12

1. Arbitrage steps fi forward market rate is higher than interest rate parity:

Answer 12

1. Buy currency A at R_A
2. Exchange currency A for currency B at spot rate
3. Invest B at R_B
4. Enter into forward contract to sell B (BxR_B) at forward rate
5. (At end of time t:) Sell B at market price
6. Return loan of currency A at (A x R_A), keep difference as profit

Question 13

Uncovered interest rate parity

Answer 13

Arbitrage not available to align currency exchange rates with interest rates, so value of currency changes

1. Given quote of A/B:
   
   1. If foreign currency is 2% higher, foreign currency expected to depreciate by 2%

Question 14

Forward Rate Parity

Answer 14

forward rate equals expected future spot rate; forward rate is “unbiased predictor”

Question 15

• Domestic Fisher Relation

Answer 15

Question 16

• International Fisher Relation:

Answer 16

Question 17

Absolute Purchasing Power Parity

Answer 17

• – Compares average price of basket of goods b/t coutries
  
  1. S(A/B) = CPI(A) / CPI(B)

Question 18

Relative Purchasing Power Parity

Answer 18

exchange rates should offset price effects of inflation difference b/t two countries

1. If A has inflation = 6%, and inflation(B) = 4%, then currency A will depreciate by 2% relative to B

Question 19

EX-Ante Version of PPP

Answer 19

Uses expected inflation instead of actual

Question 20

Relationships b/t all these

Answer 20

• Covered interest parity holds by arbitrage. If forward rate parity holds, so does uncovered rate parity
• Interest rate differentials should mirror inflation differentials. If this holds we can use inflation to forecast future exchange rates
• If ex-ante PPP and Int Fisher both hold, then uncovered interest rate parity holds too
• Uncovered interest rate parity and PPP are not bound by arbitrage and seldom work over short and medium term
• Int. Fiser effect assumes no difference in risk premiums which is actually untrue

Question 21

FX carry trade

Answer 21

• Investment in higher yielding currency using funds borrowed in lower yielding currency for profit. Lower yield currency called “funding currency”
  
  1. Return = Interest Earned – Funding Cost – Currency depreciation
     
     1. Depreciation = [(1/Spot - 1/Future ER)]/(1/Spot ER)
     2. Only works if uncovered interest rate parity does NOT hold
     3. Return distribution not normal, probability of high loss, especially during volatile times

Question 22

Current account –

Answer 22

• – measures exchange of goods, services, investment incomes and gifts. Tracks if these were at surplus or deficit
  
  1. Influence – deficit leads to currency depreciation via:
  2. Flow supply/demand mechanism – value of currency decreases, which may restore deficit to balance depending on:
     
     • Initial deficit
     • Influence of exchange rates of import/export prices
     • Price elasticity of demand of traded goods
  3. Portfolio balance mechanism – investor country rebalances portfolio
  4. Debt sustainability mechanism – level of debt gets too high relative to GDP

Question 23

Financial account (Capital)

Answer 23

• – flow of funds for debt and equity investments
  
  1. If current account deficit, capital account surplus required to keep currency from depreciating
  2. Capital account influences – major determinant of exchange rate, too much flow can lead to currency appreciation, can create problems as:
     
     • Excessive appreciation of domestic currency
     • Bubbles
     • Increased external debt
     • Excessive consumption in domestic market via credit

Question 24

Mundell-Fleming model

Answer 24

• – impact of monetary and fiscal policy on interest rate (and exchange rate) for the short term. Changes in inflation rate not specifically modelled

Question 25

Flexible Exchange rate

Answer 25

• Rates determined by supply and demand in foreign markets. International capital flow can be restricted or not.

Question 26

Effects of capital mobility with different policies

Answer 26

Question 27

Fixed exchange rate

Answer 27

• – Govt fixes exchange rate of domestic currency to major currency
  
  1. Expansionary monetary policy leads to depreciation of domestic currency, the govt would then have to purchase its own currency in the foreign exchange market which reverses the expansionary stance

Question 28

Monetary approach to exchange rate determination

Answer 28

• only take into account the effect of monetary policy on exchange rates
  
  • Pure monetary model
  • Dornbusch overshooting model

Question 29

Pure monetary model

Answer 29

1. – PPP holds at any point in time and output is held constant.
   
   1. Expansionary monetary or fiscal policy leads to increase in prices and decrease in value of domestic currency
   2. X% increase in money supply leads to an x% increase in price levels and x% depreciation in domestic currency
   3. Doesn’t account for expectations about future monetary expansion or contraction

Question 30

Dornbusch overshooting model

Answer 30

1. – assumes prices are sticky (inflexible) in short term so don’t reflect changes in monetary policy immediately (PPP does not hold)
   
   1. Expansionary monetary policy leads to price increases but over time. Leads to decrease in interest rates, larger than PPP implied depreciation of domestic currency due to capital outflow. In long term exchange rates increase toward PPP implied value

Question 31

Portfolio balance (asset market) approach to exchange rate determination

Answer 31

• – focuses only on effects of fiscal policy (not monetary) in the long term view
• Deficit – must borrow money from investors. Investors earn return based on both debts yield and currency return
• Combining the Mundell-Fleming and portfolio balance approaches, we find that in the short term, with free capital flows, an expansionary fiscal policy leads to domestic currency appreciation (via high interest rates). In the long term, the government has to reverse course (through tighter fiscal policy) leading to depreciation of the domestic currency. If the government does not reverse course, it will have to monetize its debt (i.e., print money—monetary expansion), which would also lead to depreciation of the domestic currency

Question 32

Pull factors

Answer 32

• favourable developments that make a country favourable for foreign capital
  
  1. Ex. Price stability, flexible exchange rate regime, improced fiscal position, privatization of state owned enterprises

Question 33

Push factors

Answer 33

mobile international capital seeking higher returns

Question 34

• Capital controls or central bank intervention in FX markets

Answer 34

1. Objectives:
   
   1. Ensure domestic currency does not appreciate excessively
   2. Allow the pursuit of independent monetary policies without being hindered by their impact on currency values
   3. Reduce aggregate volume of inflow of foreign capital
2. Effectiveness
   
   1. Not effective for developed countries
   2. Unclear for developing

Question 35

• Warning signs of currency crisis

Answer 35

1. Terms of trade deteriorate
2. Fixed exchange rates
3. Foreign exchange reserves dramatically decline
4. Currency value has risen above historical mean
5. Inflation increases
6. Liberalized capital markers
7. Money supply increases relative to bank reserves
8. Banking crises