You are on page 1of 39

CHAPTER 10

CURRENCY EXCHANGE RATES:


DETERMINATION AND FORECASTING
Presenters name
Presenters title
dd Month yyyy

1. INTRODUCTION
An exchange rate is the price of one currency in terms of another.
Forecasting exchange rates is challenging because
- Macroeconomic variables are not as variable as exchange rates.
- Exchange rates are volatile in the short term.
- Using trends to forecast exchange rates is not productive.

Copyright 2014 CFA Institute

2. FOREIGN EXCHANGE MARKET CONCEPTS


A quoted exchange rate reports the amount of the price currency equivalent
to one unit of the base currency:
=
The bid and offer (also known as ask) price are in terms of the price currency.
- The bid price is the price at which the counterparty is willing to buy one unit
of the base currency.
- The offer price is the price at which the counterparty is willing to sell one unit
of the base currency.

Copyright 2014 CFA Institute

SIZE OF THE BID/OFFER SPREAD


The bid/offer spread is compensation for the counterparties providing
exchanges.
- The bid/offer spread in the interbank market is narrower than that available to
others.
- Spreads are in terms of pips. A quote of 1.5400/1.5423 has a spread of
1.5423 1.5400 = 23 pips.
The size of the spread is a function of liquidity in the market, which depends on
- the currency pair (obscure cross-rates have wider spreads),
- the time of day (more liquid at open),
- market volatility (the more uncertain, the more volatile), and
- the relationship between the dealer and client (there is competition among
dealers for clients).

Copyright 2014 CFA Institute

ARBITRAGE
If rates are not consistent with
(1) offer > bid and
(2) cannot buy and sell in different markets and make a profit,
then participants will buy and sell and such arbitrage will force rates into
compliance.
Triangular arbitrage is taking advantage of incorrect exchange rates and such
actions ensure that cross-rates are consistent.
In any examination for violations of arbitrage constraints,
1. the bid must be less than the offer price.
2. violations of the arbitrage constraints are rare.
3. cross-rates are produced automatically based on spot exchange rates.

Copyright 2014 CFA Institute

CROSS-RATES BASED ON SPOT RATES:


EXAMPLE
Consider the bid/offer of USD/EUR is 1.3633/1.3637 and of GBP/USD is
0.6090/0.6092. What is the GBP/EUR?

= 0.830766
= 0.830250
Therefore, the GBP/EUR is 0.830250/0.830766.

Copyright 2014 CFA Institute

TRIANGULAR ARBITRAGE: EXAMPLE


Example
Suppose you have the following quotes:
EUR/USD = 0.8734
EUR/GBP = 1.4654

Sell
Sell USD
USD for
for EUR
EUR
$100,000
$100,000 == 87,340
87,340

USD/GBP = 1.6824
Is there an arbitrage opportunity?
Check:

Sell
Sell EUR
EUR for
for GBP
GBP
87,340/1.4654
87,340/1.4654 == 59,601
59,601

0.8734 0.8710 Yes


Sell
Sell GBP
GBP for
for USD
USD
59,601

1.6824
=
59,601 1.6824 = $100,273
$100,273
Profit
Profit of
of $273
$273

Copyright 2014 CFA Institute

COVERED INTEREST RATE PARITY


A forward contract is an agreement to exchange one currency for another at
some future date.
A spot rate is a current rate of exchange.
If forward rate > spot rate, the difference is the forward premium.
If forward rate < spot rate, the difference is the forward discount.
The relationship between spot and forward rates depends on the interest rates
in the two countries: Notation is foreign/domestic = f/d.
Covered interest rate parity is the relationship between spot and forward
rates based on the relative interest rates of the two countries:

Copyright 2014 CFA Institute

FORWARD PRICING: EXAMPLE


Example
Suppose that the USD/EUR spot rate is 0.73565 and that iUSD = 3% and
iEUR = 4%. This implies a 90-day forward rate of:

Because , there is a forward discount.


The forward discount is = 0.73565 0.73383 = 0.00182.

Copyright 2014 CFA Institute

MARK-TO-MARKET VALUE
Mark-to-market value for forward contracts is the profit or loss that would result
from closing out a position at current market prices.
- Mark-to-market is zero at inception of the contract, but then changes over the
life of the contract.
- It requires the price of an opposite forward position and discounting to the
present.
- The appropriate bid or offer prices are necessary: offer for buy, bid for sell.

Copyright 2014 CFA Institute

10

MARK-TO-MARKET VALUE: EXAMPLE


Original position

1. Determine price
1. Determine
of offsettingprice
of
offsetting
position
position
2. Calculate profit
2. or
Calculate
loss profit
or loss
3. Discount the
or loss
3. profit
Discount
the to
the
present
profit
or loss to
the present

Sold forward 10 million EUR for delivery against the USD


in nine months at a rate of 1.36530 USD/EUR.
Three
Three months
months pass
pass
Buy forward EUR for delivery against the USD in six
Buy
forward
forisdelivery
against the USD in six
months:
OfferEUR
price
1.36325.
months: Offer price is 1.36325.
(1.36530 1.36325) 10 million = $20,500
(1.36530 1.36325) 10 million = $20,500
If the discount rate is 3%, the present value of the profit six
months from now is
Present value = $20,197.04

Copyright 2014 CFA Institute

11

3. A LONG-TERM FRAMEWORK FOR


EXCHANGE RATES
A parity condition is a relationship between or among variables that would exist
in an ideal world.
- Parity conditions in exchange rates give us a view of the long-term
relationships among spot exchange rates, forward exchange rates, inflation,
interest rates, and expectations.
Covered interest rate parity is a condition in which a foreign money market
instrument that is completely hedged against exchange rate risk should provide
the same return as a domestic money market instrument.
- It assumes transaction costs are zero and that the money market instruments
are similar with respect to liquidity, maturity, and default risk.
Uncovered interest rate parity is a condition in which the expected return on
an unhedged foreign currency investment is equal to the return on a comparable
domestic currency investment, which is equal to the money market yield.
- If there are different interest rates in the two countries, the spot exchange rate
would change to compensate so that the condition holds.
Copyright 2014 CFA Institute

12

PURCHASING POWER PARITY


Purchasing power parity (PPP) is the condition in which a good or service is
priced the same in different countries once it is adjusted for exchange rates.
- Based on the law of one price, identical goods and services trade at the
same price across countries.
- Purchasing power parity provides a reasonable estimate of fair value of an
exchange rate in the long run (but not in the short run).

Copyright 2014 CFA Institute

13

VERSIONS OF PPP
The absolute version of PPP states that the spot exchange rate between two
countries is determined solely by the ratio of their national price levels (Pf,/Pf):

Sf / d Pf / Pd

- It assumes that there are no transaction costs and that all goods and
services are tradable.
The relative version of PPP states that the change in exchange rates
between two countries currencies ( %Sf/d) is determined by the difference
between the foreign and domestic inflation rates (f, d).

%Sf / d f d

The ex ante version of PPP is similar to the relative version but is stated with
respect to expected, not actual, inflation rates.

Copyright 2014 CFA Institute

14

FISHER EFFECTS
The Fisher effect is the relationship that exists among the real interest rate (r),
the expected inflation rate (e), and the nominal interest rate (i):
i = r + e
The international Fisher effect is that there is a relationship between nominal
interest rates of countries (if, id) that is explained by the difference in expected
rates of inflation ( ,): .

Copyright 2014 CFA Institute

15

LINK AMONG SPOT EXCHANGE RATES, FORWARD


EXCHANGE RATES, AND INTEREST RATES
Ex ante
purchasing
power parity

Foreign
domestic
expected
inflation
differential

International
Fisher effect

Copyright 2014 CFA Institute

Expected
change in
the spot
exchange
rate

Uncovered
interest
rate parity

Foreign
domestic
interest
rate
differential

Forward rate
as an
unbiased
predictor

Forward
premium
or
discount

Covered
interest rate
parity

16

FORECASTING FUTURE SPOT


EXCHANGE RATES
The forward rate is an unbiased predictor of the future spot rate if both covered
and uncovered interest rate parity hold.
- But forward rates are poor predictors of future spot exchange rates because
uncovered interest rate parity is often violated.
If all the international parity conditions hold at all times, then

- If all parity conditions hold, there are no excess returns to FX trading.


In the short run, there is a great deal of volatility and it is difficult to predict
future spot exchange rates.

Copyright 2014 CFA Institute

17

ESTIMATING THE LONG-RUN FAIR VALUE


OF AN EXCHANGE RATE
The International Monetary Funds Consultative Group on Exchange Rate Issues
(CGER) suggests three approaches to estimating the long-run equilibrium
exchange rate:
1. The macroeconomic balance approach estimates how much exchange rates
need to change to equate a countrys medium-term current account imbalance
to that countrys normal (that is, equilibrium) current account imbalance.
2. The external sustainability approach estimates how much exchange rates
would need to adjust to equate the countrys ratio of net foreign asset to GDP or
its ratio of net foreign liability to GDP to some benchmark level (that is, to
stabilize), given a medium-term growth rate.
3. The reduced form econometric model estimates the equilibrium real
exchange rate for the currency based on key medium-term macroeconomic
variables (e.g., net foreign asset position, terms of trade).

These three approaches, when used together along with country-specific


information, can provide information on the fair value of exchange rates.

Copyright 2014 CFA Institute

18

4. CARRY TRADE
Foreign exchange carry trade is a strategy in which there is a long position in
high-yielding currencies (that is, countries with higher interest rates) and short
positions in low-yielding currencies (that is, countries with lower interest rates,
referred to as funding currencies).
- Risk: uncertainty regarding the exchange rate of the two countries
currencies.
According to uncovered interest rate parity, carry trades should not produce
excess returns because the interest rates between the two currencies should
be reflected in the exchange rate.
Evidence indicates excess returns to this strategy, which may be attributable to
the riskiness of the high interest rate currencies (highly leveraged position).

Copyright 2014 CFA Institute

19

CARRY TRADE: EXAMPLE


Action

Description

Cash flow

Borrow in A

Borrow 10 million in Country A at 3%

+10.0000 millionA

Convert A to B

Convert Country A currency into Country B


currency at a spot rate of 1.5000

10.0000 millionA
+15.0000 millionB

Buy bonds in B Purchase Country Bdenominated bonds


yielding 5%

15.0000 millionB

One year later

B bonds mature: 15 millionB 1.05

+15.7500 millionB

Convert Country A currency at a spot rate


of 1.5200: 15.75 millionB/1.52000

15.7500 millionB
+10.3618 millionA

10 millionA 1.03

10.3000 millionA

Repay A loan
Profit

Copyright 2014 CFA Institute

0.0618 millionA

20

5. THE IMPACT OF BALANCE OF PAYMENT


FLOWS
Changes in the exchange rate are a mechanism for the balancing of the
current account (the flows of the real economy) and the capital account
(financial flows).
The dominant factor in explaining exchange rate movements are
investment/financing decisions.
1. The price of real goods and services adjust more slowly than exchange
rates and asset prices.
2. Production of goods and services takes time, and demand decisions are
subject to inertia.
3. Investment/financing decisions reflect the reallocation of existing portfolios
in addition to current expenditures.
4. Expected exchange rate changes can induce large short-term capital flows.

Copyright 2014 CFA Institute

21

BALANCE OF PAYMENTS AND


EXCHANGE RATES
Current account imbalances affect exchange rates.
- Flow supply/demand channel: If a country exports more than it imports,
demand for its currency increases, resulting in currency appreciation.
- Portfolio balance channel: A country operating at a trade surplus will have
more of a deficit countrys currency than it wants, resulting in downward
pressure on the deficit countrys currency.
- Debt sustainability channel: If a country runs persistent deficits, it will be
indebted to foreigners and, eventually, its currency will be depreciated so that
the current account deficit narrows.
Capital flows can strain an emerging market through appreciation in currency,
increase in indebtedness, market bubbles, domestic credit, or overinvestment
in risky projects.

Copyright 2014 CFA Institute

22

6. MONETARY AND FISCAL POLICIES


The MundellFleming model is a model of a small but open economy and
describes the relationship between the exchange rate, interest rates, and GDP.
Expansionary Monetary Policy

Expansionary Fiscal Policy

Flexible
exchange
rates

Interest rates decline

Downward pressure on currency

Increase net exports

Increase interest rates

Upward pressure on currency

Currency may appreciate or depreciate

Fixed
exchange
rates

Buy own currency to prevent


depreciation

Increase interest rates

Sell currency to prevent appreciation

Expand money supply

Copyright 2014 CFA Institute

23

MUNDELLFLEMING
HIGH CAPITAL MOBILITY
Expansionary
Monetary
Policy

Restrictive
Monetary
Policy

Expansionary
Fiscal Policy

Ambiguous

Domestic
Currency
Appreciates

Restrictive
Fiscal Policy

Domestic
Currency
Depreciates

Ambiguous

Copyright 2014 CFA Institute

LOW CAPITAL MOBILITY


Expansionary
Monetary
Policy

Restrictive
Monetary
Policy

Expansionary
Fiscal Policy

Domestic
Currency
Depreciates

Ambiguous

Restrictive
Fiscal Policy

Ambiguous

Domestic
Currency
Appreciates

24

MONETARY POLICY AND EXCHANGE RATES


In the monetary approach, output is fixed, so the monetary policy affects
exchange rates through prices and inflation.
- Approach is based on the idea that the relative price of currencies is a function
of the relative supply of and demand for the currencies.
- With flexible exchange rates, a change in the money supply will cause a
change in equilibrium and the nominal exchange rates (and hence, cause a
change in exchange rates).
- Dornbusch overshooting model assumes that output prices are limited in
flexibility in the short run but flexible in the long run.
- An increase in the money supply increases price levels and results in a
depreciation in the currency.
The Taylor rule relates the nominal interest rate to the real interest rate, the
actual rate of inflation, the deviation from the expected rate of inflation, and the
deviation of actual GDP from potential GDP.
Historically, changes in monetary policy have affected exchange rates.
Copyright 2014 CFA Institute

25

FISCAL POLICY AND EXCHANGE RATES


Fiscal policy effects on exchange rates are ambiguous because of the many
channels possible.
The portfolio balance approach to exchange rates assumes that investors
hold diversified portfolios of stocks and bonds, domestic and foreign.
- When a country runs sustained deficits, investors require higher returns,
which leads to higher interest rates and/or the depreciation of the currency.
Increase in
real interest
rate differential
Expansive
fiscal policy

Currency
appreciates
Central bank
monetizes debt

Government
debt buildup

Currency
depreciates

Fiscal stance
turns restrictive

Copyright 2014 CFA Institute

26

EXCHANGE CHANGE IN EXCHANGE RATE


Approach

Condition Assuming
Mobile Capital

Result
Depreciation
Appreciation

Balance of payments

Persistent deficit
Persistent surplus

MundellFleming

Expansionary monetary policy


Restrictive monetary policy
Expansionary fiscal policy
Restrictive fiscal policy

Monetary approach

Monetary expansion
Monetary contraction

Asset market approach

Persistent deficit
Persistent surplus

Copyright 2014 CFA Institute

27

EFFECTS OF MONETARY AND FISCAL POLICIES


ON EXCHANGE RATES
Expansionary monetary policy results in an increase in the supply of the
currency and, therefore, a depreciation in the currency.
- Contractionary monetary policy has the opposite effect.
Expansionary fiscal policy results in an increase in interest rates, which attracts
capital and increases the value of the currency.
- Contractionary fiscal policy has the opposite effect.
What if there are both monetary and fiscal policies at work?
- When both the monetary and fiscal policy are expansionary, the effect on
exchange rates is not clear.
- When both the monetary and fiscal policy are restrictive, the effect on
exchange rates is not clear.

Copyright 2014 CFA Institute

28

7. EXCHANGE RATE MANAGEMENT:


INTERVENTION AND CONTROLS
Capital inflows can be good for the economy because they bridge the gap between
domestic investment and savings.
Capital inflows can be harmful to an economy if they result in bubbles or if the
reversal of these flows results in a depreciation of the countrys currency and/or an
economic downturn.
Capital inflows may be a result of encouragement of foreign capital investment into
the country or of other pull forces (e.g., liberalization of financial markets,
sovereign ratings upgrades) or of push (that is, external) factors, such as mobile
capital.
Goal of intervention: to prevent or mitigate surges in capital flows.
- Allow currency to appreciate if undervalued.
- Intervene in the foreign exchange market if overvalued.
- Expand monetary base (pushing interest rates lower)unsterilized intervention.
- Sell securities to take care of excess liquiditysterilized intervention.
- Institute capital controls.
Copyright 2014 CFA Institute

29

EFFECTIVENESS OF CENTRAL BANK ACTIONS


The effectiveness of central bank intervention is mixed.
Capital controls:
- Capital controls, if used inappropriately, can exacerbate a situation (e.g., use
when not needed, circumvention of controls by market participants, spillover
to other countries).
- The evidence is mixed, but in general, capital controls do not reduce capital
inflows.
FX market intervention:
- In developed countries, the FX market is so large that central bank actions
are too small to be effective.
- Intervention lowers foreign exchange volatility in emerging markets but does
not appear to affect exchange rates.

Copyright 2014 CFA Institute

30

8. CURRENCY CRISES
A currency crisis is an economic downturn that is the result of a depreciation of
a countrys currency and subsequent instability in exchange rates.
Currency crises do not appear to be anticipated, although there are warning
signs.
An effective warning system must use macroeconomic indicators with current
data and be broad based because there are usually a number of issues with
countries undergoing a currency crisis.
Warning signs:
- Deterioration of trade balance
- Decline in foreign exchange reserves
- Higher rates of inflation
- Increase in money supply
- Private credit growth
- Boombust cycle in financial markets
Copyright 2014 CFA Institute

31

9. SHORTER-TERM FORECASTING TOOLS


Fundamentals-based forecasting models can explain long-term trends but are
not useful for short-term trends in exchange rate movements.
Methods of forecasting short-term rates:
- Technical analysis: In previous decades, trend-based models had some
ability to predict exchange rate movements, but more recently, these models
perform poorly.
- Wide swings in exchange rates are less common, so it is less probable that
a technical analyst can earn excess returns.
- Some excess returns in FX in emerging markets are possible because
excess profits have not yet been arbitraged away or because these
currencies have appreciated over time.
- Other market indicators are order flow, sentiment, and positioning.

Copyright 2014 CFA Institute

32

CONCLUSIONS AND SUMMARY


Spot exchange rates apply to trades for the next settlement date for a given
currency pair, whereas forward exchange rates apply to trades to be settled at a
longer maturity.
- Market makers quote bid and offer prices (in terms of the price currency) at
which they will buy or sell the base currency, and the offer price is always
higher than the bid price.
- The bid/offer spread depends on (1) the currency pair involved, (2) the time of
day, (3) market volatility, (4) the transaction size, and (5) the relationship
between the dealer and client.
Forward exchange rates are quoted in terms of points to be added to the spot
exchange rate. If the points are positive, the base currency is trading at a
forward premium; if negative, the base currency is trading at a forward discount.
Forecasting the direction of exchange rate movements can be a daunting task.
Most studies find that models that work well in one period or for one set of
exchange rates fail to work well for others.

Copyright 2014 CFA Institute

33

CONCLUSIONS AND SUMMARY


International parity conditions show us how expected inflation, interest rate
differentials, forward exchange rates, and expected future spot exchange rates
are linked in an ideal world.
With the exception of covered interest rate parity, which is enforced by arbitrage,
the key international parity conditions rarely hold in either the short or medium
term. However, the parity conditions tend to hold over relatively long horizons.
According to the theory of covered interest rate parity, an investment in a foreign
currencydenominated money market investment that is completely hedged
against exchange rate risk in the forward market should yield exactly the same
return as an otherwise identical domestic money market investment.
According to the theory of uncovered interest rate parity, the expected change in a
domestic currencys value should be fully reflected in domesticforeign interest
rate spreads.
According to the ex ante purchasing power parity condition, expected changes in
exchange rates should equal the difference in expected national inflation rates.

Copyright 2014 CFA Institute

34

CONCLUSIONS AND SUMMARY


Most studies find that high-yield currencies do not depreciate and low-yield
currencies do not strengthen as much as yield spreads would suggest over
short- to medium-term periods.
If both ex ante purchasing power parity and uncovered interest rate parity held,
real interest rates across all markets would be the same.
The international Fisher effect is that the nominal interest rate differential
between two currencies equals the difference between the expected inflation
rates.
If both covered and uncovered interest rate parity hold, the forward exchange
rate would serve as an unbiased predictor of the future spot exchange rate.
The purchasing power parity approach to assessing long-run fair value
probably has the widest following among international economists.

Copyright 2014 CFA Institute

35

CONCLUSIONS AND SUMMARY


The macroeconomic balance approach to assessing long-run fair value in the
foreign exchange market is used to estimate how much exchange rates need to
adjust to bring a countrys current account balance to a sustainable level.
A useful model of longer-term exchange rate determination is the combination of
convergence to a long-run equilibrium real exchange rate and uncovered interest
rate parity.
For the most part, countries that run persistent current account deficits see their
currencies weaken over time. Similarly, countries that run persistent current
account surpluses tend to see their currencies appreciate over time.
The relationship between current account imbalances and changes in exchange
rates is not contemporaneous; large current account imbalances can persist for
long periods of time before they trigger an adjustment in exchange rates.
A significant adjustment in exchange rates is often required to facilitate
correction of a large current account gap.

Copyright 2014 CFA Institute

36

CONCLUSIONS AND SUMMARY


Greater financial integration of the worlds capital markets and the increased
freedom of capital to flow across national borders have increased the
importance of global capital flows in determining exchange rates.
In the MundellFleming model, monetary policy affects the interest rate
sensitivity of capital flows, strengthening the currency when monetary policy is
tightened and weakening it when monetary policy is eased.
- The more sensitive capital flows are to the change in interest rates, the
greater the exchange rates responsiveness to the change in monetary policy.
In the monetary model of exchange rate determination, monetary policy is
deemed to have a direct impact on the actual and expected path of inflation,
which, via purchasing power parity, translates into a corresponding impact on
the exchange rate.
Although monetary policy impulses may be transmitted to exchange rates
through a variety of channels, the end result is broadly the same: Countries that
pursue overly easy monetary policies will see their currencies depreciate over
time.
Copyright 2014 CFA Institute

37

CONCLUSIONS AND SUMMARY


Fiscal policy has an ambiguous impact on the exchange rate.
- Under conditions of high capital mobility, countries that simultaneously
pursue expansionary fiscal policies and relatively tight monetary policies
should see their currencies strengthen over time.
The portfolio balance model of exchange rate determination asserts that a
steady increase in the stock of government debt outstanding will be willingly
held by investors only if they are compensated in the form of a higher expected
return.
Surges in capital inflows can be a curse if they fuel boom-like conditions, asset
price bubbles, and an overshoot of exchange rates into overvalued territory.
The International Monetary Fund now considers capital controls to be a
legitimate part of a policymakers toolkit to prevent exchange rates from
overshooting, asset price bubbles from forming, and future financial conditions
from deteriorating.

Copyright 2014 CFA Institute

38

CONCLUSIONS AND SUMMARY


The evidence indicates that intervention by industrial countries has had an
insignificant impact on the course of exchange rates, but the evidence is more
mixed for emerging markets.
Technical analysis is a popular trading tool for many, if not most, FX market
participants. Updated studies for the post-1995 period indicate that trendfollowing trading rules do not produce excess returns.
Although technical analysis may now be less useful as a strategic tool to enhance
return, a number of studies show that technical analysis may be a useful tool in
managing the downside risk associated with FX portfolios.
Most studies find that there exists a strong positive, contemporaneous
relationship between cumulative order flow and exchange rates over short
periods of time. However, the evidence is more mixed regarding whether order
flow has predictive value for exchange rates.
Empirical studies find that neither the data on currency risk reversals nor data on
the size and trend in reported net speculative positions on the futures market are
useful for currency forecasting purposes.
Copyright 2014 CFA Institute

39