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CFA Level II Economics > Reading 14 - Currency Exchange Rates > Flashcards

Reading 14 - Currency Exchange Rates Flashcards

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1
Q

Explain an exchange rate quote of 1.4126 USD / EUR

A
  • Each euro costs $1.4126
  • The euro is the base currency and the USD is the price currency
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2
Q

What is a forward exchange rate?

A

A currency exchange rate for an exchange to be done in the future

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3
Q

If a dealer quotes the euro at $1.4124 - 1.4128, what does the mean?

A
  • $1.4124 is the bid price, which is the price the dealer will buy euros
  • $1.4128 is the ask price, which is the price at which the dealer will sell euros
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4
Q

What are the 3 things that the spread quoted by the dealer depends on ?

A
  1. The spread in the interbank market for the same currency pair
  2. The size of the transaction
  3. The relationship between the dealer and client
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5
Q

What is the rule for the price currency?

A

Buy the price currency at bid and sell the price currency at ask

***buy at the bid, sell at the ask

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6
Q

A dealer is quoting the AUD/GBP spot rate as 1.5060 - 1.5067.

Compute the proceeds of converting 1 million GBP……

A

We are going up the quote, so we use the bid price of 1.5060 and multiply

1 million GBP * 1.5060 = 1,506,000 AUD

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7
Q

What is the rule to determine whether we divide by or multiply by when converting currencies using spot rates?

A

“up-the-bid and multiply, down-the-ask and divide”

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8
Q

A dealer is quoting the AUD/GBP spot rate as 1.5060 - 1.5067.

Compute the proceeds of converting 1 million AUD

A

We are going down the quote, so we use the ask price and divide

1 million AUD / 1.5067 = 663,702.13 GBP

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9
Q

If we are given three pairs of of currencies.

What is the cross rate for the (B/C) bid ?

A
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10
Q

If we are given three pairs of currencies.

What is the cross rate for the (B/C) offer ?

A
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11
Q

The following quotes are available from your dealer:

USD / AUD 0.6000 - 0.6015

USD / MXN 0.0933 - 0.0935

Compute the implied MXN / AUD cross rate

A
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12
Q

What is the value of a forward currency contract prior to expiration called?

A

mark-to-market value

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13
Q

How do you calculate the mark-to-market value?

A
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14
Q

What does the word “covered” mean in the context of interest parity?

A

It means bound by arbitrage

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15
Q

When does covered interest rate parity hold?

A

when any forward premium or discount exactly offsets differences in interest rates, so that an investor would earn the same return investing in either currency

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16
Q

Given a A/B quote structure, what is the formula for the Forward rate if covered interest rate parity exists?

A
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17
Q

What does uncovered interest rate parity mean?

A

When arbitrage is not able to force the forward exchange rate to a level consistent with the difference between the two country’s nominal interest rates

***This can happen if forward currency contracts are not available or if capital flows are restricted to prevent arbitrage

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18
Q

What is the formula for uncovered interest rate parity to hold?

A
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19
Q

When is the forward rate considered an unbiased predictor of the future spot rate?

A

if the forward rate is equal to the expected future spot rate

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20
Q

What is the formula for the International Fisher effect, which compares the nominal interest rates and inflation rates between two countries?

A
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21
Q

What is absolute purchasing power parity (aka absolute PPP) ?

A

It compares the average price of a representative basket of consumption goods between countries

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22
Q

What is relative purchasing power parity (relative PPP) ?

A

States that changes in exchange rates should exactly offset the price effects of any inflation differential between the two countries.

23
Q

What is the equation for relative PPP?

A
24
Q

What is the ex-ante version of PPP ?

A

It uses expected inflation instead of actual inflation

25
Q

What is the real exchange rate ?

A

The rate between a currency pair that includes an adjustment for inflation differentials between two countries since a base year

26
Q

What is the formula to calculate the real exchange rate ?

A
27
Q

Describe what Balance-of-payment (BOP) accounting is……

A

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

28
Q

What is the balance-of-payments (BOP) equation?

A

current account + financial account + official reserve account = 0

29
Q

What is the current account?

A

Measures the exchange of goods, the exchange of services, the exchange of investment income, and unilateral transfers (gifts to and from other nations)

30
Q

What is the financial account (aka capital account) ?

A

measures the flow of funds for debt and equity investment into and out of the country

31
Q

What are the 3 ways that current account deficits lead to a depreciation in the domestic currency?

A
  1. Flow Supply/Demand Channel - deficits in a country increase the supply of that currency in the market. This puts downward pressure on the exchange rate
  2. Portfolio Balance Channel - countries with current account surpluses usually have capital account deficits. When the country decides to rebalance their investment portfolios, it can have significant negative impact on the value of the investee currency ie.. China liquidating some of its Treasurys if it deems they hold to many..The dollar would go down if this occured
  3. Debt Sustainability Channel - A country running a current account deficit may be running a capital surplus by borrowing from abroad. If debt gets too high as a %, investors may question the sustainability and lead to rapid depreciation
32
Q

What are the 4 problems that are created by excessive capital flows into emerging markets ?

A
  1. Excessive real appreciation of the domestic currency
  2. Financial asset and/or real estate bubbles
  3. Increase in external debt by businesses or government
  4. Excessive consumption in the domestic market fueled by credit
33
Q

How is the real exchange rate (A/B) calculated

A
34
Q

What is the Taylor Rule?

A

it links the central bank’s policy rate to economic conditions (employment level and inflation) and can be used to forecast exchange rates

35
Q

What is the equation for the Taylor Rule ?

A
36
Q

What are the 3 ways the IMF assesses long-term equilibrium real exchange rates?

A
  1. Macroeconomic balance approach - estimates how much current exchange rates must adjust to equalize a country’s expected current account imbalance
  2. External sustainability approach - estimates how much current exchange rates must adjust to force a country’s external debt relative to GDP towards its sustainable level
  3. Reduced-form economic model approach - estimates the equillibrium path of exchange rate movements based on pattern in several key macroeconomic variables (trade balance, net foreign asset/liability, relative productivity)
37
Q

What is an FX carry trade?

A

When an investor invests in a higher yielding currency using funds borrowed in a lower yielding currency

***the lower yielding currency is called the base currency

38
Q

How are the return distribution of an FX carry trade characterized?

A

Negative skewness and excess kurtosis (ie fat tails)

39
Q

What is crash risk?

A

the probability of large loss in a carry trade

40
Q

What are the two approaches to managing crash risk?

A
  1. Volatility filter - whenever implied volatility increases above a certain threshold, the carry trade positions are closed
  2. Valuation filter - a valuation band is established for each currency based on PPP. If the value of a currency falls below the band, the trade will overweight that currency in the traders portfolio
41
Q

What is the Mundell-Fleming model?

A

it evaluates the impact of monetary and fiscal policies on interest rates - and consequently on exchange rates

***Changes in inflation rates due to changes in monetary/fiscal policy are not explicitly modeled by this model

42
Q

What occurs during expansionary monetary policy?

A
  • lowering of interest rates, consequently the inflow of capital investment in physical and financial assets
  • this decreases financial inflows which reduces demand for the domestic currency, resulting in depreciation of the domestic currency
43
Q

What occurs during expansionary fiscal policy?

A
  • an increased deficit occurs from either lower taxes or higher government spending with increased government borrowing and real interest rates
  • An increase in real interest rates will attract foregin investors, improve the financial account, and consequently increase demand for the domestic currency
44
Q

What are the main assumptions of monetary models?

A

We assume that output is fixed, so that monetary policy primarily affects inflation which in turn affects exchange rates

45
Q

What are the two main approaches to monetary models?

A
  1. Pure monetary model - the PPP holds at any point in time and output is held constant. It does not take into account expectations about future monetary expansion or contraction
  2. Dornbusch overshooting model - assumes prices are sticky (inflexible) in the short term and hence, do not immediately reflect changes in monetary policy
46
Q

What are the objectives of capital controls or central bank intervention in FX markets ?

A
  • Ensure that the domestic currency does not appreciate excessively
  • Allow pursuit of independent monetary policies without being hindered by their impact on currency values
  • Reduce excessive inflow of foreign capital
47
Q

What are some of the warning signs of a coming currency crisis that the IMF found?

A
  1. Terms of trade deteriorate
  2. Official foreign exchange reserves dramatically decline
  3. Real exchange rate is substantially higher than the mean-reverting level
  4. Inflation increases
  5. Equity markets experience a boom-bust cycle
  6. Money supply relative to bank reserves increases
  7. Nominal private credit growth
48
Q

What are the 3 uses of technical analysis in forecasting exchange rates?

A
  1. Trend-following trading rules - things like moving average crossover trading rules or filters.
  2. FX Dealer Order Books - in FX markets, volume and price data is not immediately available to all parties. B/C of this, an FX dealer’s book may have predictive value
  3. Currency Options Market - implied volatility estimates from foreign exchange options can give insight into markets expectation of future increases or decreases in the value of a currency
49
Q

The domestic (DC) interest rate is 9% and the foreign (FC) interest rate is 7%. If the forward exchange rate is DC/FC is 5.00, what is the spot exchange rate that is consistent with covered interest parity?

A
50
Q

Given the data provided and assuming that the exchange rates are currently at equilibrium, which country would see their real exchange rate appreciate?

A

The difference in real interest rate and risk premium drive short term appreciation/depreciation of a currency.

Since country A has the largest difference, it’s currency will appreciate the most

51
Q

What does the Portfolio Balance (Asset Market) model state?

A

focuses on the long-term implications of sustained fiscal policy ( deficit or surplus) on currency values.

52
Q

Explain what happens during Expansionary Monetary Policy?

A

Growth increases when interest rates are lowered to stimulate increased investment and consumption spending.

**Think the FED

53
Q
A

CFA Level II Economics (3 decks)

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