EXCHANGE RATE AND INTEREST RATE FLUCTUATIONS Flashcards
What determines the level of the spot exchange rate?
Balance of payments
Purchasing power parity
Interest rate parity theory
Four way equivalences
BALANCE OF PAYMENTS
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.
What are the components of balance of payments?
Current account Financial account (capital account & reserve account)
What is the UK’s current account made up of?
- Balance of trade
- Balance of services
- Balance of income
- Current transfers
Describe balance of payments
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.
What are the three outcomes of balance of payments?
1. Current account = SURPLUS Financial account = DEFICIT 2. Current account = DEFICIT Financial account = SURPLUS 3. Current account and financial account in balance
Reasons for a current account deficit.
- 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
What is the relationship between the exchange rate and balance of payments
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.
BALANCE OF PAYMENT EQUILIBRIUM
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/
How is a balance of payment deficit corrected?
- 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.
Why is depreciation of the home currency not a perfect solution?
- Inelastic imports/exports
- Counter-pricing by competitors
- Delay to interaction with other currencies
PURCHASING POWER PARITY THEORY
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
ABSOLUTE PPP
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.
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/€)
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
What are the assumptions of absolute PPP?
- No transaction costs
- No barriers to trade
- Homogeneous products
Why do the conditions of absolute PPP rarely hold?
- Applies only to traded and uniform products
- Transaction costs prevail
- “Big Mac index”
RELATIVE PPP
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
Formula for relative PPP
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
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
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
What are the limitations of relative PPP?
- 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.
ARBITRAGE
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
Types of arbitrage
- Locational arbitrage
- Triangular arbitrage
- Covered interest arbitrage
INTEREST RATE PARITY THEORY
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.
Interest rate parity theory formula
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