Module 5.3: Exchange Rate Determinants, Carry Trade, and Central Bank Influence

Question 1

The FX carry trade attempts

Answer 1

to capture an interest rate differential and is a bet against uncovered interest rate parity

Question 2

FX Carry

Answer 2

an investor invests in a higher yielding currency using funds borrowed in a lower yielding currency. The lower yielding currency is called the funding currency.

If the higher yield currency does not depreciate by IR differential, the investor makes a profit

Question 3

Profit on FX Carry Trade

Answer 3

interest differential - change in spot rate of investment currency

Question 4

Risks of the Carry Trade

Answer 4

Crash risk
return distribution characterized by negative skewness and excess kurtosis (i.e., fat tails)

Question 5

Balance-of-payments

Answer 5

used to keep track of transactions between a country and its international trading partners

Question 6

Current Account Influences on Exchange Rates

Answer 6

Flow supply/demand mechanism.
Portfolio balance mechanism.
Debt sustainability mechanism.

Question 7

Flow supply/demand mechanism.

Answer 7

Current account deficits downward pressure on the exchange value of that currency. The decrease in the value of the currency may restore the current account deficit to a balance—depending on the following factors:
-The initial deficit.
-The influence of exchange rates on domestic import and export prices.
-Price elasticity of demand of the traded goods.

Question 8

Portfolio balance mechanism.

Answer 8

Countries with current account surpluses usually have capital account deficits may find their portfolios’ composition being dominated by few investee currencies. When investor countries decide to rebalance their investment portfolios, it can have a significant negative impact on the value of those investee country currencies.

Question 9

Debt sustainability mechanism.

Answer 9

A country running a current account deficit may be running a capital account surplus by borrowing from abroad. When the level of debt gets too high relative to GDP, investors may question the sustainability of this level of debt, leading to a rapid depreciation of the borrower’s currency.

Question 10

Mundell-Fleming Model

Answer 10

evaluates the short-term impact of monetary and fiscal policies on interest rates—and consequently on exchange rates.

Question 11

High Capital Mobility

Answer 11

international capital flows are relatively unrestricted

Question 12

low mobility of capital

Answer 12

international capital flows are restricted

Question 13

Monetary and Fiscal Policy under Mundell-Fleming Model

Answer 13

Question 14

Monetary Approach to Exchange Rate Determination

Answer 14

 Pure monetary model.
 Dornbusch overshooting model.

Question 15

 Pure monetary model.

Answer 15

PPP holds at any point in time and output is held constant. An expansionary (restrictive) monetary policy leads to an increase (decrease) in prices and a decrease (increase) in the value of the domestic currency.

Question 16

 Dornbusch overshooting model.

Answer 16

A restrictive (expansionary) monetary policy leads to an excessive appreciation (depreciation) of the domestic currency in the short term and then a slow depreciation (appreciation) in the long term PPP value.

Question 17

portfolio balance approach to Exchange Rate Determination

Answer 17

takes a long-term view and evaluates the effects of a sustained fiscal deficit or surplus on currency values.

Question 18

Approaches to Exchange Rate Determination

Answer 18

Monetary Approach
portfolio balance approach
Mundell-Fleming Model

Question 19

The objectives of capital controls or central bank intervention in FX markets are to:

Answer 19

Ensure that the domestic currency does not appreciate excessively.
Allow the pursuit of independent monetary policies without being hindered by their impact on currency values.
Reduce the aggregate volume of inflow of foreign capital.