Reading 6: Currency Exchange Rates: Understanding Equilibrium Value Flashcards
Spread Quoted by Dealer
- spread in interbank market
- size of the transaction
- relationship between dealer and client
Interbank spread on currency pairs
- currencies involved
- time of day
- market volatility
Rules for FOREX Quotes
- Buy the base currency at ask and sell the base currency at bid
- Buy the price currency at bid and sell the price currency at ask
- Up-the-bid-and-multiply
- Down-the-ask-and-divide
Cross Rate w/ bid-ask spreads
(A/C)bid = (A/B)bid x (B/C)bid
(A/C)offer = (A/B)offer x (B/C)offer
(B/C)bid = 1/(C/B)offer
(B/C)offer = 1/(C/B)bid
Mark-to-market value
Vt = ((FPt - FP)(contract size))/(1+R(days/360))
Fpt = forward price (to sell base currency) at time t in the market for a new contract maturing at time T FP = forward price specified in the contract at inception (to buy the base currency) R = interest rate of price currency
Covered Interest Rate Parity
- holds 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.
- bound by arbitrage
- “no arbitrage forward rate”
F = [(1+Ra (days/360)]/(1+Rb (days/360)] x So
F-So = ([(1+Ra (days/360)]/(1+Rb (days/360)]-1) x So
Uncovered Interest Parity
- not bound by arbitrage
- “expected future spot rate”
-Ex: Country A has IR of 4% and Country B has IRS of 9%. Currency B is expected to depreciate by 5% annually relative to A so investor is indifferent between A or B.
Forward Rate Parity
- if the forward rate is equal to the expected future spot rate, we say the forward rate is an unbiased predictor of the future spot rate.
- When F = E(S1), this is called forward rate parity
Domestic Fisher
Rnominal = Rreal + E(inflation)
International Fisher Relation
Rnominal A - Rnominal B = E(inflationA) - E(inflationB)
Purchasing Power Parity
-the law of one price states that identical goods should have the same price in all locations (does not hold in practice due to effects of friction such as tariffs and transportation costs)
- Absolute purchasing power parity does not focus on individual products, but compares the average price of a representative basket of consumption goods between countries
- Requires the law of one price to only be correct on average
S(A/B) = CPI(A) / CPI(B)
Relative purchasing power parity
- changes in exchange rates should exactly offset the price effects of any inflation differential between two countries.
- Ex: If Country A has inflation of 6% and Country B has inflation of 4%, then Country A’s currency should depreciate by approx. 2% relative to Country B’s currency over the period.
%change in S(A/B) = Inflation A - Inflation B
-violation of relative PPP in the short run are common
Ex-Ante Version of PPP
-same as relative purchasing power parity, but it uses expected inflation instead of actual inflation
Important Observations
- Covered Interest rate parity holds by arbitrage. If forward rate parity holds, uncovered interest rate parity holds.
- Interest rate differentials should mirror inflation differentials. This holds true if the international Fisher relation holds. If that is true, we can also use inflation differentials to forecast future exchange rates - which is the premise of the ex-ante version of PPP
- If the ex-ante version of relative PPP as well as the international Fisher relation both hold, uncovered interest rate parity will also hold.
Forward Rates and Unbiased Predictors
-We can use ex-ante PPP, uncovered interest rate parity or forward rates to forecast future spot rates.
- Uncovered IR parity and PPP are not bound by arbitrage and seldom work over the short and medium terms.
- The forward rate is not an unbiased predictor of future spot rates.
- PPP holds over reasonably long time horizons.
- If relative PPP holds at any point in time, the real exchange rate would be constant.
