Reading 14: Currency Exchange Rates (Determination & Forecasting) Flashcards
Calculate and Interpret the bid-ask spread on a spot or forward foreign currency quotation and describe the factors that affect the bid-offer spread.
Factors affecting the bid-offer spread:
- The spread in the interbank market
- Size of the transaction
- Dealer/client relationship
- Forward spreads are positively related to maturity
Identify a triangular arbitrage opportunity, and calculate its profit, given the bid-offer quotations for three currencies.
Triangular arbitrage opportunity: when converting to one currency, and then to another results in a profit.
REMEMBER
- Up-the-bid, multiply
- Down-the ask, divide
Always want to sell the overvalued currency and buy the undervalued currency
Distinguish between spot and forward rates and calcualte the forward premium/discount for a given currency.
Spot rate: exchange rates for immediate delivery
Forward rate: exchange rates for currency exchange on a specified future date
Forward premium/discount calculation:
When the base currency:
- forward value < spot value: refereed to as weak currency and the currency is expected to depreciate
- forward value > spot value: referred to as strong currency, and is expected to appreciate
Calculate the mark-to-market value of a forward contract.
Mark-to-market value: see formula sheet for ugly forumula
- If long, go down and use the ask quote for the original, and use the bid quote on the future
- if short, go up and use the bid quote for the original, and use the ask quote on the future
Explain international parity relations (covered and uncovered interest rate parity, purchasing power parity, and the international Fisher effect.)
- Covered interest rate parity (CIRP): changes in interest rates will just offset differences in interest rates
- Currency wwith higher nominal interest rate will depreciate
- When CIRP holds, an investor will make the same return holding either currency
- Uncovered interest rate parity: will hold when relative PPP and international Fisher effect holds
- Purchasing power parity: changes in exchange rates will just offset changes in price levels
- International Fisher effect: countries with high interest rates should have currency values that fall over time. *Real interest rates should be the same across countries
Describe relations among the international parity conditions.
Relations among the international parity conditions:
- Covered interest rate pairty (CIRP) will always hold
- IFF the forward rate is an unbiased predictor of future spot rates, then UIRP will hold
- Relative PPP + International Fisher Effect = UIRP holds
Evaluate the use of the current spot rate, the forward rate, purchasing power parity, and uncovered interest parity to forecast future spot exchange rates.
Evaluate?
Explain approaches to assessing the long-run fair value of an exchange rate.
Approaches:
- Macroeconomic balance: clues from current account deficits
- External sustainability approach: clues from external debt relative to GDP
- Reduced from econometric approach: estimation of equilibrium exchange rate path consistent with several key macroeconomic variables
Describe the carry trade and its relation to uncovered interest rate parity and calculate the profit from a carry trade.
Carry trade: if UIRP does not work you can profit by investing in high yielding currency and borrow the lower yielding currency. Crash risk is non-normal distribution of carry trade returns
Relation to uncovered interest rate parity: the differential is bigger than the amount of currency depreciation leaving room for profit
Calculating profit: Return = interest earned on investment - funding cost - currency depreciation
Explain how flows in the balance of payment accounts affect currency exchange rates.
Current account influences
- Flow mechanism
- Portfolio composition mechanism
- Debt sustainability mechanism
* Deficits eventually cause currency to depreciate
Capital account:
- In the short term, real currency values fluctuate around its long-term PPP-implied equilibrium value
- The real value is positively related to real interest rate differential and negatively related to risk premium differential
Describe the Mundell-Fleming model, the monetary approach, and the asset market (portfolio balance) approach to exchange rate determination.
Mundell-Fleming model: see picture (impact of short-term implications of fiscal policy)
Monetary approach: PPP holds at any point in time. Expansionary (restrictive) monetary policies lead to higher (lower) inflation and depreciation (appreciation) of currency.
Portfolio Balance: looks at long-term implications of fiscal policy. In the long term governments may find it increasingly difficult to fund sustained deficits, leading to depreciation of currency
Forecast the direction of the expected change in an exchange rate based on balance of payment, Mundell-Fleming, monetary, and asset market approaches to exchange rate determination.
Balance of payment:
Mundell-Fleming:
Monetary:
Asset market approaches:
Explain the potential effects of monetary and fiscal policy on exchange rates.
Monetary policy:
Fiscal policy:
Describe objectives of central bank intervention and capital controls and describe the effectiveness of intervention and capital controls.
Objectivess of central bank intervention:
- Ensure that domestic currency does not appreciate excessively
- Allow the pursuit of independent monetary polices
- Reduce excessive inflow of capital
Capital controls: can buy or sell domestic currency
Effectiveness: size and persistence of flows IFF the size of the central bank reserve is large relative to the daily trading volume
Describe warning signs of a currency crisis.
Warning signs:
- Terms of trade deteriorate
- Dramatic decline in official foreign exchange reserves
- Real exchange rates substantially higher than mean reverting level
- Inflation increases
- Equity markets experience boom-bust cycle
- Money supply relative to bank reserve increases
- Nominal private credit grows
