Forces driving Exchange Rate

Question 1

What are the forces driving the Exchange Rate

Answer 1

Investments and trading opportunities

Question 2

Key concepts trading opportunities

Answer 2

Current account BOP, real exchange rate, PPP

Question 3

Definition BOP

Answer 3

Records all transactions between a country and the rest of the world

Question 4

Formula BOP

Answer 4

Capital account = current account

Question 5

Explain current account

Answer 5

Its the difference between: exports and imports. Its for commercial transactions

Question 6

Explain capital account

Answer 6

Its the difference between: savings and investments. Its for private capital flows.

Question 7

What is the role of the current account in currency crises?

Answer 7

The current account has large deficits so more imports than exports meaning low competitive advantage

Question 8

What to do with a deficit in the current account?

Answer 8

Use of the deficit: Productive investment. Financing of the account: foreign direct investments

Question 9

Real Exchange Rate?

Answer 9

The real exchange rate is the comparison between 2 countries, showing the competitiveness as Q

Question 10

Formula Q

Answer 10

Q = (S * P* ) / P, where S = P* / P

Question 11

Interpretation of Q

Answer 11

If Q decreases, then real appreciation so the competitiveness decreases. If Q increases, then real depreciation so the competitiveness increases

Question 12

Definition of PPP

Answer 12

Are the rates of currency conversion that equalize the purchasing power of different currencies by eliminating the difference in price levels

Question 13

Absolute PPP

Answer 13

States that the spot rate is determined by the relative price difference of a basket of goods (BigMac)

Question 14

Formula Absolute PPP

Answer 14

S(ppp) = P* / P assuming that Q = 1

Question 15

Relative PPP

Answer 15

Changes in the spot exchange rate are results of the difference in inflation in different countries, assuming that Q stays constant.

Question 16

Formula Relative PPP

Answer 16

%cS = Inflation(pie) - inflation(pie)*

Question 17

When does PPP hold?

Answer 17

• long term; prices of goods react slowly due to trade barriers
• in times with high inflation; exchange rates differ then otherwise there is an arbitrage opportunity

Question 18

Types of Investment opportunities (that drives the Q)

Answer 18

The capital account of BOP, expected economic growth, UIP and CIP, Risk premia

Question 19

Expected economic growth measurement

Answer 19

Economic growth is measured in % real GDP change. Where real gdp = I + G + C + ( X - I )

Question 20

Drivers of long-term economic growth

Answer 20

1. Invested capital 2. Employment and skills 3. Technological progress; “productive capital”

Question 21

Drivers of short-term economic growth

Answer 21

Is dependent on the business cycle which is demand driven. If demand is low -> recession / depression -> deflation. If demand is high -> overheating -> inflation

Question 22

Definition CIP

Answer 22

Covered Interest parity is the relationship between interest differentials and the forward premia. It assumes no uncertainty and risk since all the prices are fixed. When its not in equilibrium there is an arbitrage opportunity

Question 23

Arbitrage

Answer 23

Buying commodities in one market and selling them in another for a higher price

Question 24

Formula CIP

Answer 24

F / S = (1+i(euro)) / (1+i(dollar))

Question 25

Definition UIP

Answer 25

Its the same as the CIP however the expected future spot rate is used as forward rate. Meaning that uncertainty and risk are involved since the expected future spot rate can differ.

Question 26

Formula UIP

Answer 26

Se / S = (1+i(euro)) / (1+i(dollar))

Question 27

Conclusion UIP

Answer 27

UIP says that the interest rate differentials between countris are equal to the expected exchange rate movements. So: i = i* + %cS

Question 28

Assumptions CIP

Answer 28

No arbitrage opportunities due to using forward contract

Question 29

Assumptions UIP

Answer 29

1. Perfect capital mobility: an unlimited amount of CF’s in response to the slightest change in interest rates.
2. Perfect capital substitutability, no risk premiu

Question 30

Relationship between UIP and Risk premia

Answer 30

Investor wants to be compensated for additional risk of investing in a foreign country, called the risk premium. So i(euro) < i(dollar) + %cS, if difference than thats the risk premia

Question 31

How to asses this risk?

Answer 31

1. amount of debt outstanding. 2. lax fiscal policy 3. high current account deficits (gives low competitiveness)