Study Session 4 - Currency Exchange Rates

Question 1

What is an exchange rate?

Answer 1

The price of one currency in terms of another. 1.33 USD/CAD would mean each CAD dollar would cost 1.33.

Question 2

What is spot rate? Forward rate? Forward Contract?

Answer 2

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.

Question 3

What is a bid ask spread?

Answer 3

Quote for a ex rate 1.4250-1.4255 price at which the dealer with buy/sell resp.

Question 4

What is the spread? What determines the spread from a dealer?

Answer 4

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.

Question 5

What is the interbank spread for a currency pair dependent on?

Answer 5

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.

Question 6

What factors effect spreads on forward contracts?

Answer 6

Increase with maturity. Longer contracts are less liquid, counterparty risk increases with length, and interest rate risk becomes an issue for longer contracts.

Question 7

What is the base and price currency? What is the rule for what rate to use?

Answer 7

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

Question 8

What are name of the two rules for conversions?

Answer 8

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

Question 9

What is a cross rate?

Answer 9

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.

Question 10

How are cross rate complicated by Bid-Ask spreads?

Answer 10

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

Question 11

What is a forward premium/discount?

Answer 11

Premium is F > S₀. Premium = F-S₀
Discount if smaller.

Given in pips +/- 1/10000

Question 12

Formula for value of a forward contract

Answer 12

Vt = (FPt - FP) (Contract Size)

Vt= Value
FPt= forward price at time T
FP=Forward price locked in at inception

Question 13

What is mark-to-market value of a forward contract?

Answer 13

The value prior to expiration.

Vt=(FPt-FP)(Contract Size)
———————
[1+R(days/360)]

days remaining

Question 14

How do you close out forward?

Answer 14

Offset the opposite contract.

If USD/CAD and buying CAD to start (down, ask)
Offset with same amount of USD (up, bid), use bid.

Question 15

What is the covered interest rate parity?

Answer 15

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.

Question 16

Formula for Covered Interest Rate Parity

Answer 16

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.

Question 17

What is the uncovered interest rate parity and equation?

Answer 17

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.

Question 18

According to Fisher, what is the nominal rate equation and what is the real interest rate parity?

Answer 18

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.

Question 19

What is purchasing power parity? Absolute purchasing power parity?

Answer 19

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.

Question 20

What is Relative Purchase power Parity? Formula? What is Ex-Ante PPP?

Answer 20

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.

Question 21

What is the formula for real exchange rate?

Answer 21

real exchange rate = St (CPIb/CPIa)

CPI = consumer price index at time t
St = spot rate given at time t A/B

Question 22

What is the balance of payments? Formula?

Answer 22

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

Question 23

What is the current account?

Answer 23

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.

Question 24

What is the financial/capital account?

Answer 24

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.

Question 25

What is the official reserve account?

Answer 25

transactions made from reserves held by the official monetary authorities of the country. Doesn’t change much.

Question 26

How does current account deficit cause depreciation of the currency?

Answer 26

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.

Question 27

How was portfolio composition mechanism effect exchange rates?

Answer 27

Countries with current account surpluses usually have capital account deficits, which typically take the form of investment in countries with current account deficits.

Question 28

How does the debt sustainability mechanism depreciate exchange rates?

Answer 28

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.

Question 29

How does the capital account affect exchange rate?

Answer 29

As capital flows into the country, demand for the currency increases, appreciating it.

Question 30

What are some problems associated with excessive capital inflows for emerging markets?

Answer 30

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.

Question 31

What is the long term equilibrium exchange rate? What are some observations from this equation?

Answer 31

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.

Question 32

What is the Taylor Rule? Formula?

Answer 32

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)

Question 33

What are the 3 approaches the IMF use to judge long term fair exchange rate?

Answer 33

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.

Question 34

How does a FX Carry Trade work? What are the risks?

Answer 34

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.

Question 35

What are the two risk management strategies for FX carry trades?

Answer 35

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.

Question 36

What is the effect of expansionary monetary policy on interest and exchange rates? Expansionary fiscal policy?

Answer 36

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.

Question 37

What are the two monetary models? What is a monetary model?

Answer 37

Under Monetary models we assume output is fixed so that monetary policy effects inflation and therefore rates.

1. 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.
2. 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.