Reading 14: Currency Exchange Rates Determination & Forecast

Question 1

What is the base currrency and what is the price currency?

Answer 1

USD/CHF

CHF= base currency

USD = Price currency

Question 2

What factors affect the spread of a currency pair

Answer 2

• Currency Pair involved
• time of the day
• market volatility
• size of the transaction
• dealer/client relationship

Question 3

What are Cross Rates?

Answer 3

Cross rates are the exchange rate between two pairs implied by their echange rates with a common third currency.

Example: USD/GBP and CHF/USD

Common Currency = USD

To calculate: CHF/GBP = USD/GBP x CHF/USD

Question 4

What is the Triangle for currencies and how does that work?

Answer 4

The conversion from one currency into another can be graphically represented by a graph of a triangle.

In conversion we can follow 2 paths:

1. Exchange currency (CHF) for another currency (GBP) at the CHF/GBP rate
2. Excahnge currency (CHF) for USD at the CHF/USD rate and then convert USD to GBP at the USD/GBP rate.

Conditon: The two paths must yield the same results!!! NO ARBITRAGE!

Question 5

How to work with Bid-Ask rates in Cross Rates?

Answer 5

1. Compute both bid and ask rates

Multiply Bid x Bid and you get Crossrate BID

Multiply Ask x Ask and you get Crossrate ASK

Also CHF/USD ASK = [1 / (USD/CHF BID)]

Question 6

How does Traingular Currency Arbitrage work?

Answer 6

If there is arbitrage possibility, you can risk free convert and make money. The rule that can be followed is as folloiwng:

• USD
• EUR

Up the BID -> Convert EUR into USD

and Down the Ask -> Convert USD into EUR

Question 7

Is the (bid-ask) spread smaller or larger than calculated spot rates?

Answer 7

The Spreads are larger for Forward Rates!

Question 8

What zijn Forward Discounts or Premiums?

Answer 8

A forward discount: Forward value < Spot Value

• Means that it is a weak currency
• Currency is expected to depreciate

A forward premium: Forward value > Spot Value

• Referred to as a strong currrency
• Currency is expected to appreciate

Question 9

How do you value a Mark-to-market of a Forward?

Answer 9

After inception, a forward contract is valued assuming an offsetting position:

• Vt = (FP_t - FP)(Contract size)
• [1 + R (Days/360)]

FP_t = Forward price at time t in the market for a new contract with the same maturity T

R = interest rate in the price currency

LONG FORWARD EUR vs USD means BUY EUR vs USD

Question 10

What is Covered Interest Rate Parity (CIRP) ?

Answer 10

CIRP: Changes in exchange rates will just offset differences in interest rates.

Forward = SPOT x

1+R_{countercurrency} (n/360) . 1+R_basecurrency (n/360)

Point: The currency with the HIGHER nominal interest rate will DEPRECIATE!

Point: When CIRP holds, an investor will make the same return holding either currency

Question 11

What is Relative PPP?

Answer 11

Relative PPP is the Purchasing Power Parity.

The changes in exchange rates will just offset changes in price levels.

i=inflation

• S₀ x [1+i_{countercurrency}]^t= E(S_t)
• 1+i_basecurrency

E(St) = Expected FUTURE SPOT at Time t

Question 12

What is the International Fisher effect?

Answer 12

Countries with high interest rates should have currency values that fall over time.

Point: Inflation differentials between countries are the prime drivers of interst rate differentials.

Intuition: REAL interest rates should be the same across countries.

Interest rate differentials are offset by currency value differences.

Question 13

What is Uncovered interest rate Parity?

Answer 13

• S₀ x 1+r_{countercurrency} (n/360) = E(S_t)
• 1+r_basecurrency(n/360)

This shows the link between:

• spot exchange rates S0
• Expected spot exchange rate E(Sn)
• Nominal Interest Rates (r)

r = i +µ

Question 14

Balance of Payment Accounts: Which accounts and what are the influences?

Answer 14

• Current Account influences:

flow mechanism, portfolio composition mechanism, debt sustainability mechanism.

Point: deficits eventually cause currency to depreciate.

• Capital (financial) Accounts:

Short run: real currency values fluctuate around its LR PPP implied equilibrium

The real value is positively related to real interst rate differential and negatively related to risk premium differential.

Question 15

What did Mundell - Flemming do?

Answer 15

The Mundell Flemming Model focuses on the interest rate and Capital flow on impact of currency:

MP & FP expans / Low CF => Depreciation

MP & FP expans / High CF => uncertain

MP expans & FP restr / low CF => uncertain

MP expans. & FP restr. with high CF => Depreciation

MP Restr. & FP expans. with high CF => Appreciation

MP Restr. & FP expans. with Low CF => uncertain

MP Restr. & FP restrictive. with high CF => uncertain

MP Restr. & FP restrictive. with low CF => Appreciation