EXCHANGE RATE AND INTEREST RATE FLUCTUATIONS

Question 1

What determines the level of the spot exchange rate?

Answer 1

Balance of payments
Purchasing power parity
Interest rate parity theory
Four way equivalences

Question 2

BALANCE OF PAYMENTS

Answer 2

Summary of transactions between domestic and foreign residents over a specified period of time.

• Imports
• Exports
• Cross-border investments
• Stocks
• Bond
• Real Estate

Detailed information concerning the demand and supply of a currency.

Helps to evaluate the performance of a country in international competition.

Question 3

What are the components of balance of payments?

Answer 3

Current account
Financial account (capital account & reserve account)

Question 4

What is the UK’s current account made up of?

Answer 4

• Balance of trade
• Balance of services
• Balance of income
• Current transfers

Question 5

Describe balance of payments

Answer 5

HOME CURRENCY:

• Held by residents of the home country
• Offered to buy foreign goods or to invest abroad
• Recorded as a “-“ transaction in the balance of payments

TRANSACTION:
For every £1 supplied for foreign currency (-£1)
£1 must be demanded by foreign currency (+1£)
Transactions should balance and total £0

FOREIGN CURRENCY
Amount of foreign currency depends on the exchange rate - this changes on a daily basis.

Question 6

What are the three outcomes of balance of payments?

Answer 6

1. Current account = SURPLUS
Financial account = DEFICIT
2. Current account = DEFICIT
Financial account = SURPLUS
3. Current account and financial account in balance

Question 7

Reasons for a current account deficit.

Answer 7

• Overvalued exchange rate
• High consumer spending
• Unbalanced economy
• Competitiveness
• Growing deficit in investment incomes

In particular for UK:

• Deficit of goods
• Financial account surplus
• Relatively low savings rate

Question 8

What is the relationship between the exchange rate and balance of payments

Answer 8

UK IMPORTERS - UK firms importing must use GBP to buy foreign currency - representing a supply of pounds.

FOREIGN FIRMS BUYING UK EXPORTS - Foreign firms buying UK exports need to convert their foreign currency to buy pounds - demand for pounds.

CURRENCY MARKET - supply and demand of GBP will determine the price of the pound.

Question 9

BALANCE OF PAYMENT EQUILIBRIUM

Answer 9

If an exchange rate is floating, the supply of currency will always be equal to the demand for currency, and the balance of payments zero.

In times of a BoP deficit, this means that the supply of the home currency (i.e. dollars) exceeds the demand in the FOREX markets - Infer that US dollar would be under pressure to depreciate.

In times of a BoP surplus, the home currency would be likely to appreciate/

Question 10

How is a balance of payment deficit corrected?

Answer 10

• Depreciation of the home currency
• J - curve effect

At time 0 a trade deficit exists - the currency begins to depreciate.
For the first three months (example), the trade deficit worsens as the currency depreciates.
Imports slow down due to higher prices
Curve increases - exports cheaper and increase
Curve is positive - exports cheaper, imports more expensive, improved balance if export volumes increase and import volumes decrease sufficiently.

Question 11

Why is depreciation of the home currency not a perfect solution?

Answer 11

• Inelastic imports/exports
• Counter-pricing by competitors
• Delay to interaction with other currencies

Question 12

PURCHASING POWER PARITY THEORY

Answer 12

Bases its predictions of exchange rate movement on changing patterns of trade due to different inflation rates between countries.

Two forms:
Absolute PPP
Relative PPP

Question 13

ABSOLUTE PPP

Answer 13

Commodities should cost the same, regardless of what currency is used to purchase it or where it is selling.

E.g. product baskets sold in the UK and USA
If price is lower in the UK, (measured using a common currency, US residents will import cheaper UK products.
Price charged in each country will adjust, and/or; exchange rate may adjust.

Question 14

ABSOLUTE PPP EXAMPLE:
If grapes were being sold for €2 per kg in France, whereas in the US the price is $3 per kg.
What happens if the exchange rate is different from the answer? ($1.2815/€)

Answer 14

Absolute PPP implies:
P(US) = S0 * P(Euro)

$3 = S0 * €2
S0 = $3/€2 = $1.50/€

If the exchange rate is anything other that $1.50/€:

Assume $1.2815/€

• Trader could buy a kg of grapes in France
• Ship them to the US and sell for $3
• Trader converts $3 into euro at $1.2815/€ = 3/1.2815 = €2.341
• Gain of €0.341 per kg

Question 15

What are the assumptions of absolute PPP?

Answer 15

• No transaction costs
• No barriers to trade
• Homogeneous products

Question 16

Why do the conditions of absolute PPP rarely hold?

Answer 16

• Applies only to traded and uniform products
• Transaction costs prevail
• “Big Mac index”

Question 17

RELATIVE PPP

Answer 17

The relative form accounts for the possibility of market imperfections:

• Transport costs
• Tariffs
• Quotas

This version of the PPP acknowledges imperfections, and highlights that the price of a basket of goods in different countries will not necessarily be the same price when measured in a common currency.
FOCUS: Rate of Change

Question 18

Formula for relative PPP

Answer 18

ef = (1+Ih)/(1+If) - 1
Simplified relationship:
ef = Ih - If
Ih = If + ef

Where: 
ef = %change in exchange rate (defined as home currency per foreign currency)
S0 = current spot rate
S1 = expected future rate
If = inflation in the foreign currency
Ih = inflation in the home currency

Application of the PPP:
St+1 = S0 * (1 + ef)
St+1 = expected future rate

Question 19

Relative PPP example:
Assume you can purchase a new laptop in the US for $3,000.

Assume that both GBP and USD are at PPP equilibrium. i.e. the current spot
rate of $1.50/£

Laptop cost 
$3,000 = £2,000
Estimated inflation
5% = 3%
Cost in one year:
$3,150 = £2,060

Answer 19

Law of one price = $3,150 = £2,060
Percentage change in exchange rate: ef = ((1+Ih)/(1+If))-1 = ((1+0.05)/(1+0/03)) - 1 = 1.9417%
Future spot rate = 1.50 * (1+0.019417) = $1.5291

Question 20

What are the limitations of relative PPP?

Answer 20

• Inflation is difficult to predict -> future inflation rates are unpredictable and can only be an estimate.
• 98% of the market is dominated by speculation - based transactions, rather than trade transactions. PPP breaks down.
• Government intervention.

Question 21

ARBITRAGE

Answer 21

Making a profit from discrepancies in quoted prices

• Usually v. low risk
• Does not require investment funds to be tied up for a period of time

Question 22

Types of arbitrage

Answer 22

• Locational arbitrage
• Triangular arbitrage
• Covered interest arbitrage

Question 23

INTEREST RATE PARITY THEORY

Answer 23

Covered interest arbitrage no longer feasible, due to an equilibrium state, known as IRP.

Definition: the difference between the spot and the forward exchange rates is equal to the difference between interest rates available in the two currencies/countries.

Cannot use the carry trade to profit as any interest rate advantage in the foreign country will be offset by the discount on the prevailing spot rate in the future.
i.e. you cannot borrow money at a low interest rate in one country, exchanging for foreign currency and investing at the higher interest rate.

Question 24

Interest rate parity theory formula

Answer 24

p = (1+ih) / (i+if) - 1

p = movement in the value of foreign currency (premium) 
ih = interest rate on home deposits
if = interest rate on foreign deposits

Question 25

IRP example:

Assume the interest rate in South Africa (rand) is 6% and in the UK (pound) it is
5%. Taking the perspective of a UK investor, calculate the forward premium and
the spot price one year from now. The spot rate is £0.10/rand

Answer 25

𝑝 = (1 + 𝑖ℎ) / (1 + 𝑖𝑓)− 1 = 
(1 + 0.05)/(1 + 0.06) − 1 = −0.0094339
If the spot rate is £0.10, then: 
F = S(1+p)
F = 0.10(1-0.00943) = 0.099057

Question 26

Considerations when assessing interest rate parity.

Answer 26

• Transaction costs
• Political risk
• Differential tax laws
• Changes in the forward premium

Question 27

FISHER EFFECT

Answer 27

For domestic markets:
1 + real interest rate = (1 + nominal interest rate) / (1 + inflation rate)

Approximated:
nominal rate = real interest rate + inflation rate

Question 28

Fisher effect example:
If a bond pays an interest rate of 6% per annum and inflation is
2% per annum what is the real rate of interest on the bond?

Answer 28

1 + real interest rate = 1+nominal interest rate / 1+inflation rate

1+real interest rate = 1.06 / 1.02
=1.039
real interest rate = 0.039 / 3.9%

Question 29

INTERNATIONAL FISHER EFFECT

Answer 29

Another theory that uses interest rate differentials to explain why exchange rates change over time.

High inflation = high interest rates
Low inflation = low interest rates

Expected inflation is the only factor that varies if consumers expect the same real rate of return.

ef = (1 + ih) / (i + if) - 1

Question 30

Causes of interest rate fluctuations

Answer 30

• Structure of interest rates and yield curves
• Expectations theory
• Liquidity preference theory
• Market segmentation

Question 31

Why do interest rates differ in different markets?

Answer 31

• Risk
• Basis of fractional reserve banking
• Size of borrowing
• Government policy
• Different types of financial asset
• Duration of lending

Question 32

Why is the yield curve significant?

Answer 32

Financial managers should examine the current shape of the yield curve when deciding on the term of the borrowing or deposits.

The yield curve encapsulates the markets expectations of the future movements in interest rates.

Question 33

What influences the shape of the term structure of interest rates at a particular moment?

Answer 33

Risk

Theories of term structure

Question 34

Fisher (1896) explanation of the shape and term structure of interest rates.

Answer 34

Assumes well-functioning and efficient markets.

Broadly: the current interest rates and their dynamics are shaped by the expectations on the future interest rates of market participants.

Question 35

THE EXPECTATIONS HYPOTHESIS

Answer 35

Formally:
A theory that states that in equilibrium, the investment in a series of short-term bond must offer the same expected return as an investment in a single long maturity bond. Only if this it the case will investors be prepared to hold both short and long term bonds.

(1+r2)^2 = (1 +r1)[1+E(r1,t=1)]

Question 36

Implications of the PURE expectations hypothesis

Answer 36

• Implies that only reason for downward sloping term structure is that investors expect the short-term rates to decline in the future.
• Implies the only reason for upward sloping term structure is that investors expect short-term rates to rise in the future.

Overall, the expectations for the future is the only factor that shapes the current yield curve and explains dynamics of interest rates.

Question 37

LIQUIDITY PREFERENCE THEORY

Answer 37

Ability to sell an asset at the required price
Liquidity risk: investor will have to sell the asset below its fair value.

Liquidity advocates: Market participants have preference for short term rather than LT, therefore ST investors dominate the market.

To induce ST investors to hold LT assets, a liquidity premium is needed as a form of compensation bearing risk.

Interest rates/structure is determined by future expectations of rates and the yield premium. As interest rate risk increases with maturity, the yield premium increases with maturity.

Question 38

MARKET SEGMENTATION THEORY

Answer 38

Short term v long term
Main assumption: market for ST and LT investments are segmented. Market participants in each have different:

• Preferences
• Goals
• Other characteristics

Some investors

• Focus on short term only
• Focus on long term only

A series of short term investments would not be an acceptable substitute for LT investors.

View different maturity sectors as segmented markets
These segmented sectors will have their own factors and forces that influence interest rates.
The interest rate for a bond with a given maturity is determined by the supply and demand for bonds in that segment with no effect from the returns on bonds in other segments.