Lesson 3 Flashcards
BoP in determining exchange rates
A BoP deficit, implies an excess supply of the currency which depreciate ceteris paribus
A BoP surplus implies an excess demand of the currency which should appreciate ceteris paribus
Please explain the law of one price and PPP
The law of one price states that all goods should cost the same regardless of their location. This does not hold in practice due to transportation and tariffs.
PPP (Purchasing power parity) is based on the principle of LoOP.
Absolute PPP compares a similar basked of goods and services in one country to another
Relative PPP is based on exchange rate movements and differences in inflation rates between the two countries
Please describe relative PPP and include its formula
Relative PPP states that exchange rate differences should exactly offset the price effects of inflation between the two countries
(E[St]/S0) = ((1+Idc)/(1+Ifc))^t
Where S0 is the current spot rate given
The current spot rate is 0.6525USD/AUD. The annualised Australian inflation rate is 6% over the next 6 months, and the annualised US inflation rate is 3% over the same period. What is the expected spot rate in 6 months according to relative form PPP?
E[St]/0.6525 = (1.03/1.06)^0.5
E[St] = 0.6432
Please list the empirical evidence surrounding PPP
- PPP performs better for countries within close geographical proximity.
- There are substantial and prolonged deviations from PPP.
- Exchange rates are more volatile than what PPP predicts.
- PPP holds better in the long run than in the short run.
- PPP holds better for countries with high inflation.
- PPP holds better for traded goods than for non-traded goods.
- Reversion to PPP is rather a slow process.
- PPP test is sensitive to the choice of price index.
Interest Rate Parity (IRP) - please provide brief description and formula
IRP can be divided into two: covered and uncovered.
Covered: Explains the relationship between forward exchange rate, spot exchange rate and interest rates
Uncovered: Explains the relationship between the expected exchange rate, spot exchange rate and interest rates
Covered interest parity holds when any forward premium or discount just offsets differences in interest rates so that an investor will earn the same return investing in either currency.
F/S0 = ((1+Rdc)/(1+Rfc))^t
Uncovered replaces F with E(S)
Assume the annualized US dollar interest rate is 9%, and the annualized euro interest rate is 12% when the spot exchange rate is $1.30 per euro. Calculate the expected exchange rate for a 4-month forward contract.
E(S)/1.30 = (1.09/1.12)^0.333
E(S) = 1.288USD per Euro
Please explain the forward premium/discount and provide the formula
A foreign currency is at a forward discount if it is less than the current spot rate. Here the foreign currency will depreciate in the future and vice versa
(Forward rate - spot rate)/spot rate = 360/Number of days in forward contract
International Fisher Effect (IFE) - Please provide definition and formula
IFE describes the relationship between nominal interest rate and inflation. It assumes that with a higher domestic interest rate, the currency will depreciate over time as we expect higher inflation to erode its value.
(1+Rnomd)/(1+Rnomf) = (1+E(Id))/(1+E(If))
The eurozone expected annual inflation rate is 9.0%, and the expected China inflation rate is 13%. The nominal interest rate is 5.0% in the eurozone. What is the nominal interest rate in China according to the international Fisher relation?
1.09/1.13 = 1.05/(1+Rnomcn)
Rnomcn = 8.9%
Asset market approach
The AMA, views the exchange rate as the financial price of a currency, which is determined by investors’ expectations of the future.
Therefore, only news regarding inflation and the interest rate affect the price and not trade flows and the BoP.
This implies that only news regarding inflation and real interest rates will affect the exchange rate.
According to the AMA, a sudden unexpected increase in money supply (lowering the int. rate) will first cause the home currency to decrease before it appreciates to its new equilibrium. Why?
This is because initially the lower interest rates in the US encourages investors to sell their USD and buy AUD at the promise of higher returns there.
Over time, USD will appreciate to its new equilibrium, this is because the increased money supply in the US will increase inflation thereby causing the exchange rate to increase as investors buy USD expecting a rate hike
The current spot exchange rate is 0.66 USD per Australian dollar. Suppose that the US unexpectedly increases its money supply by 3% and the US interest rates immediately drop from 4% to 3%. Assume it will take 3 years for the increase in money supply to translate into higher prices in the US. Assume both price indices are currently equal to 100. The interest rate in Australia is 4%. Calculate the short- and long-run effects on the exchange rate.
E(S3) = 0.66 * (103/100) = 0.6798
S0 = 0.6798 * 1.04^3/1.03^3
S0 = 0.6998
Please outline the various forecasting techniques
Technical forecasting - the use of historical data to predict future values
Fundamental forecasting - is based on fundamental relationships between economic variables and exchange rates.
Market-based forecasting - develops forecasts from market-based indicators like spot and forward exchange rates
Mixed forecasting - uses a mix of all of the above methods
Please explain the market efficient hypothesis
According to the market efficient hypothesis, the market can be:
Weak-from efficient: exchange rate reflects estimates of the future value of the currency; technical analysis is useless.
Semi-strong from efficient: exchange rate reacts in an immediate and unbiased way to all publicly available information.
Strong from efficient: exchange rate reflects all relevant public and private information.
