Study Session 4 - Currency Exchange Rates Flashcards
What is an exchange rate?
The price of one currency in terms of another. 1.33 USD/CAD would mean each CAD dollar would cost 1.33.
What is spot rate? Forward rate? Forward Contract?
Spot is the exchange rate for immediate delivery. Forward is the rate for a future date. 30,60,90 days.
The agreement to exchange a specific amount of one currency for a specific amount of another on a future date.
What is a bid ask spread?
Quote for a ex rate 1.4250-1.4255 price at which the dealer with buy/sell resp.
What is the spread? What determines the spread from a dealer?
Measured in pips, 1/10000, reflects the dealers profit.
Depends on: spread in the interbank market for the same currency pair.
Size of the transaction
The relationship between client and dealer.
What is the interbank spread for a currency pair dependent on?
Currencies involved. Some are more liquid than others.
Time of day - London and NY overlap is most liquid
Market Volatility - more volatility means more spread to compensate market traders for increased risk on the day.
What factors effect spreads on forward contracts?
Increase with maturity. Longer contracts are less liquid, counterparty risk increases with length, and interest rate risk becomes an issue for longer contracts.
What is the base and price currency? What is the rule for what rate to use?
In USD/CAD
CAD is the base currency
USD is the price currency
Buy the base currency at ASK, sell the base currency at BID.
Buy the price currency at BID and Sell the price currency at ASK.
BaseBuy - ASK
PriceSell - ASK
What are name of the two rules for conversions?
Up the bid and multiply
Down the ask and divide
1.5060-1.5067 AUD/GBP
Convert 1m GBP - So GBP –> up - bid - multiply
1.5060 * 1m
Convert 1m AUD - So AUD –> down - ask - divide
1m/1.5067
What is a cross rate?
The exchange rate between two currencies that is implied by the exchange rate between a common third currency. For when there is no active market for the currency pair.
So USD/AUD = 0.60, MXN/USD = 10.70
What is MXN/AUD
MXN/AUD = USD/AUD * MXN/USD, USD (the common currency here) cancels, calculate.
How are cross rate complicated by Bid-Ask spreads?
When calculating the bid-ask of the non traded pair, just make sure to use the same side of the quote for the calculation.
To get B/C bid/ask rates from A/B C/B, the following adjustments are needed:
B/C bid = 1/ C/B offer
B/C offer = 1/ C/B bid
What is a forward premium/discount?
Premium is F > S₀. Premium = F-S₀
Discount if smaller.
Given in pips +/- 1/10000
Formula for value of a forward contract
Vt = (FPt - FP) (Contract Size)
Vt= Value
FPt= forward price at time T
FP=Forward price locked in at inception
What is mark-to-market value of a forward contract?
The value prior to expiration.
Vt=(FPt-FP)(Contract Size)
———————
[1+R(days/360)]
days remaining
How do you close out forward?
Offset the opposite contract.
If USD/CAD and buying CAD to start (down, ask)
Offset with same amount of USD (up, bid), use bid.
What is the covered interest rate parity?
When any forward premium or discount exactly offsets international differences in exchange rate so that an investor would make the same investing in either currency.
Formula for Covered Interest Rate Parity
F = [1+ Ra (days/360)]
—————- (S₀)
[1+ Rb (days/360)]
F quoted as A/B S0 quoted as A/B Days in the contract Ra - Interest rate for currency A Rb - interest rate for currency B
Derives the no arbitrage forward rate.
What is the uncovered interest rate parity and equation?
Covered means that Forward prices are bound by arbitrage. Uncovered means they are not. This can be due to capital flow restrictions or forward currency contracts do not exist for a pair.
t=(1+Ra/1+Rb)^t (S₀)
Predicts the future spot rate.
If this holds, the forward rate is an unbiased predictor of the future spot rate. Both Covered and Uncovered Hold.
According to Fisher, what is the nominal rate equation and what is the real interest rate parity?
Nominal = Real + Expecting Inflation
R nominal a - R nominal b = E(inflationA)-E(inflationB)
Should hold. The difference between two countries nominal rates should be the difference between their expected inflation. No arbitrage.
What is purchasing power parity? Absolute purchasing power parity?
Identical goods should have the same price in all locations after adjusting for the exchange rate.
Usually doesn’t hold due to tariffs and transportation costs.
Absolute Purchasing power parity just demands that the law of one price holds for a basket of representative goods.
What is Relative Purchase power Parity? Formula? What is Ex-Ante PPP?
That changes in exchange rates should offset any differential between two countries actual inflation.
St = 1+inflationA ^t (S₀)
————–
1+inflationB
Ex Ante just uses expected inflation instead of actual.
What is the formula for real exchange rate?
real exchange rate = St (CPIb/CPIa)
CPI = consumer price index at time t St = spot rate given at time t A/B
What is the balance of payments? Formula?
Accounting method used to keep track of transactions between a country and its trading partners. Gov, consumer and biz transactions.
current + financial account + official reserve account = 0
What is the current account?
measures exchange of goods, exchange of services, the exchange of investment income, and unilateral transfers (gifts).
Selling more than we are buying = surplus
buying more that we are selling = deficit.
What is the financial/capital account?
Measures the flow of funds for debt and equity into and out of the country. Dominant factor in changing short term rates. Large changes, rapidly.
What is the official reserve account?
transactions made from reserves held by the official monetary authorities of the country. Doesn’t change much.
How does current account deficit cause depreciation of the currency?
Buying more than we are selling (deficit)
Flow Mechanism - Deficit increase the amount of local currency from exports exchanging into local, putting downward pressure on the exchange rate.
May return to balance depending on size of initial deficit, the influence of exchange rate on domestic import and export prices, price elasticity of demand of the traded goods.
How was portfolio composition mechanism effect exchange rates?
Countries with current account surpluses usually have capital account deficits, which typically take the form of investment in countries with current account deficits.
How does the debt sustainability mechanism depreciate exchange rates?
A country with a current acc deficit may run a capital account surplus by borrowing from abroad. When the level of debt is too high compared to GDP investor may question the sustainability and rapidly depreciate the currency.
How does the capital account affect exchange rate?
As capital flows into the country, demand for the currency increases, appreciating it.
What are some problems associated with excessive capital inflows for emerging markets?
Excessive real appreciation of the domestic currency
Financial asset bubbles
Increases in external debt by business or gov
Excessive consumption domestically fuelled by credit
Usually combated with capital controls or direct intervention in currency markets.
What is the long term equilibrium exchange rate? What are some observations from this equation?
short term rates fluctuate around the long term
given by: equilibrium real XR (A/B) + (real interest rateB-real interest rateA) - (risk premium B - risk premium A)
Risk premium A = risk premium demanded by investor for investing in assets denominated in A.
the real value of currency is positively related to real interest rates, negatively related to risk premium.
What is the Taylor Rule? Formula?
Links the central banks policy rate to economic conditions (employment and inflation) and can be used to forecast exchange rates.
r= (R- π) = rn + ⍺(π-π) + β(y-y)
R= policy rate implied by taylor rule
rn = neutral real policy interest rate
π=current inflation rate
π= target inflation rate from central bank
y= log of current output
y= log of central banks target
⍺,β= policy response coefficients >0, Taylor suggested 0.5
Real Exchange rate A/B= equilibrium exchange rate + difference in neutral real policy interest rate (B-A) + a(difference in inflation gap (B-A) + B(difference in output gap) - (risk premiumB- risk premiumA)
What are the 3 approaches the IMF use to judge long term fair exchange rate?
Macroeconomic balance - what do the exchange rates need to be to fix the current account imbalance
External Sustainability - how much do rates have to change to force a countries external debt to a sustainable level
Reduced Form econometric - estimates the equalibrium path based on several factors including trade balance, net foreign asset/liability, and relative productivity.
How does a FX Carry Trade work? What are the risks?
An investor invests in the high yield currency (higher interest rate) using funds borrowed in the lower yield currency. The low yield is the funding currency.
Works good in low volatility times. If the funding currency appreciates than there can be a loss. Negative skewness, excess kurtosis, high crash loss. If traders use a stop loss, all could exit the trade at the same time.
What are the two risk management strategies for FX carry trades?
When the implied volatility measured in the FX of equity markets is too high, positions are closed.
Valuation - a band is established for each currency based on PPP or other factors, if the currency drops below that, positions are closed.
What is the effect of expansionary monetary policy on interest and exchange rates? Expansionary fiscal policy?
Expansionary Monetary policy - Reduces the interest rate, and reduces the inflow of capital in physical and financial assets. Lowers demand for the currency, leading to depreciation.
Fiscal Policy - increase gov borrowing and real interest rates. Attracts foreign investment, improve financial account, and increases demand for the currency, appreciating it.
These changes happen in an environment of high capital mobility.
What are the two monetary models? What is a monetary model?
Under Monetary models we assume output is fixed so that monetary policy effects inflation and therefore rates.
- Pure Monetary Model - PPP holds at any point in time. Expansionary policy drives prices up, and depreciates the currency. Doesn’t include any future expectations.
- Dornbusch overshoot model - Assumes that prices are sticky and do not change immediately to monetary policy changes. This causes a decrease in real rates, and depriciation of the currency from outflows. Exchange rates in the short term will overshoot there low or high value, but over the long term correct to PPP implied levels.
