Chapter 4 - 10: Exchange Rates & Interest Rates

What is the difference between depreciation and appreciation in foreign exchange rate movements?

Depreciation is a decline in a currency’s value while appreciation is an increase in a currency’s value. A positive percent change indicates a currency has appreciated and a negative change indicates a currency has depreciated.

What does the exchange rate represent?

The price of a currency, or the rate at which one currency can be exchanged for another

Why is the demand curve of downward sloping?

The quantity demanded increases when the value of the pound decreases because consumers have a greater incentive to buy

Why is the supply curve upward sloping?

The quantity supplied increases when the value of the currency increases, because there is a greater incentive to sell it

How is equilibrium defined?

Equilibrium is when the quantity of pounds demanded equals the quantity of pounds supplied.

List the main five main factors that influence exchange rates

• Inflation rates

• Interest rates

• Income levels

• Government controls

• Expectations of future exchange rates

How does a rise in US inflation rates affect the demand for foreign goods?

This leads to a higher US demand for foreign goods and foreign currency, causing the foreign currency’s exchange rate to rise.

How does a rise in US interest rates affect the demand for foreign deposits?

This leads to a decrease in demand for foreign deposits, and increase in demand for US deposits. As a result, the demand for dollars increases, causing the exchange rate for the dollar to rise as well.

How does an increase in US income levels affect the demand for foreign goods?

This leads to an increase in US demand for foreign goods, and an increase in demand for foreign currency relative to the dollar, causing the exchange rate for the foreign currency to rise.

Briefly explain how government controls influence exchange rate

Through…

• Imposing foreign exchange barriers

• Imposing foreign trade barriers

• Intervening in foreign exchange markets

• Manipulating macro variables such as inflation, interest rates and income levels

How do rate expectations affect the demand for a currency?

If investors anticipate interests in one country will rise, they may invest in that country causing the demand for foreign currency to rise and the exchange rate for foreign currency to rise. Speculators can place downward pressure on a currency when they expect it to depreciate.

How can exchange rate signals affect currency speculation?

Speculators may overreact to signals, causing the currency to be temporarily overvalued or undervalued.

How does the liquidity of a currency’s spot market influence exchange rate fluctuations

If a currency’s spot market is liquid, then it’s exchange rate will not be sensitive to a single large purchase or sale whereas illiquid markets are highly sensitive to change

Briefly explain cross exchange rate fluctuations

Whichever currency strengthens more against the U.S. dollar will also strengthen against the other currency. If one currency stays the same against the dollar, the other currency’s gain against the dollar is also its gain against that currency.

How do financial institutions capitalize on expected exchange rate appreciation?

If financial institutions believe that a currency is valued lower than it should be in the foreign exchange market, they may invest in that currency before it appreciates.

How do financial institutions capitalize on expected exchange rate depreciation?

If a currency is expected to fall, financial institutions may borrow and sell it now, then buy it back later at a lower price to repay the loan and earn a profit.

Briefly explain the “Carry Trade” strategy

This is a strategy where investors will borrow in a currency with a low interest rate and invest in a high interest rate currency to earn profit from the interest rate spread. However this can be risky if rates move opposite to what the investors expected and losses can be magnified.

Define international arbitrage

Capitalizing on a discrepancy in quoted prices by making a risk less profit.

List the three forms of arbitrage

• Locational arbitrage

• Triangular arbitrage

• Covered interest arbitrage

Briefly explain locational arbitrage

The process of buying a currency at the location where it’s priced cheap and immediately selling it at another location where it’s priced higher.

What is triangular arbitrage?

Currency transactions in the spot market used to capitalize on discrepancies in the cross exchange rate between two countries.

How is the bid/ask spread accounted for in triangular arbitrage?

These transaction costs can reduce or even eliminate gains from triangular arbitrage.

How do I determine if I should use the bid or ask quote of a currency during triangular arbitrage?

If you want to BUY a currency, you use the ask price and if you want to SELL a currency you use the bid price.

Briefly explain the impact of triangular arbitrage on rates.

If people are buying pounds with dollars, the ask price of the pound will rise to eliminate this arbitrage opportunity. Similarly, if people are selling pounds for ringgit, the bid price of the pound will fall.

What is covered interest arbitrage?

The process of capitalizing on the interest rate differential between two countries while covering your exchange rate risk with a forward contract.

What are the two components of covered interest arbitrage?

• Interest arbitrage: The process of capitalizing on the difference between interest rates of two countries

• Covered: Hedging the position against interest rate risk

Under covered interest arbitrage, how do you determine which currency to invest in?

Compare the forward premium / discount and the interest rate gap. If the forward premium is greater than the interest rate, then foreign investment gives the better covered return (i.e borrow home currency and invest foreign).

How does realignment occur in covered interest arbitrage?

Realignment is focused on the forward rate. The forward rate is likely to experience most if not all of the adjustment needed to achieve realignment.

How is the bid/ask spread considered in covered interest arbitrage?

Investors must account for the effects of the spread between the bid and ask quotes and of the spread between deposit and loan rates.

Compare and contrast the effects of the three different kinds of arbitrage.

• The threat of locational arbitrage ensures quoted exchange rates are similar across banks in different locations

• The threat of triangular arbitrage ensures that cross exchange rates are properly set

• The threat of covered interest arbitrage ensures that forward exchange rates are properly set.

How does arbitrage reduce transaction costs?

Locational arbitrage limits the differences in a spot exchange rate quotation across locations while covered interest arbitrage ensures that the forward rate is properly priced. This allows a MNC’s manager to avoid excessive transaction costs.

Explain interest rate parity (IRP)

In equilibrium, the forward rate differs from the spot rate by a sufficient amount to offset the interest rate differential between two currencies.

How is interest rate parity derived?

The investors return from using this strategy can be calculated from

• The amount of the home currency that is initially invested

• The spot rate (S) in dollars when the foreign currency is purchased

• The interest rate on the foreign deposit

• The forward rate (F) in dollars at which the foreign currency will be converted back to USD

What are the implications of the forward premium?

If the forward premium is equal to the interest rate differential as just described, then covered interest arbitrage will not be feasible.

Does interest rate parity hold?

Compare the forward rate or discount with interest rate quotations occurring at the same time. Due to limitations in access to data, it’s difficult to obtain quotations that reflect the same point in time.

What are some factors to considerations when assessing interest rate parity?

• Transactions costs: The actual point reflecting the interest rate differential and forward rate premium, which must be far from the IRP line to make covered interest arbitrage worth it.

• Political risk: A crisis in the foreign country could cause its government to restrict any exchange of the local currency for other currencies

• Differential tax laws: May be feasible before tax returns but not necessarily after.

Briefly explain the variation in forward premiums across maturities

The annualized interest rate differential between two countries can vary among debt maturities as will the forward premiums. The forward rate is indirectly affected by factors including inflation differentials, interest rate differentials etc.

Briefly explain the absolute form of purchasing power parity (PPP)

Without trade barriers, consumers buy where prices are lower. As a result, the same basket of goods should cost the same in both countries when prices are converted into the same currency.

Briefly explain the relative form of purchasing power parity (PPP)

Due to market imperfections, prices of the same basket of products in different countries will not be the same but, the rate of changes in prices should be similar when measured in common currency.

Why is exchange rate adjustment necessary for relative purchasing power?

In order for relative purchasing power to be the same for products purchased locally or from another country, exchange rate adjustment is necessary. If the purchasing power is not equal, consumer will shift purchases to wherever products are cheaper until it balances out.

How is purchasing power parity derived?

It’s the relationship between relative inflation rates (I) and the exchange rate (e). Currencies adjust depending on inflation. If the home inflation rate is greater than the foreign inflation rate, the foreign currency appreciates and vice versa.

How can the relative form of PPP be used to estimate exchange rate effects?

It estimates how an exchange rate will change in response to the different inflation rates between countries.

What is the mechanism by which the inflation differential affects the exchange rate according to PPP?

International trade, which is reflected through the percentage change in the exchange rate.

Briefly explain purchasing power disparity

If the exchange rate doesn’t move as the PPP theory suggests, there is a disparity in the purchasing power of the two countries.

How do you test the purchasing power parity theory?

Choose two countries and compare the differential in their inflation rates to the % change in the foreign currency’s value, or apply a regression analysis to historical exchange rates and inflation differentials.

What are some of the limitations to PPP tests?

• Results vary depending on the base period used

• It can underestimate / overestimate the change in value of a currency depending on the base period

Briefly explain why PPP doesn’t hold?

• A change in a country’s spot rate is driven by more than than the inflation rate differential between two countries

• No substitutes for traded goods: If substitute goods are not available domestically, consumers may continue buying imported goods.

What is the international fisher effect (IFE)

Claims that currencies with higher interest rates are expected to depreciate, while currencies with lower interest rates are expected to appreciate.

What two components does the nominal interest rate contain?

• Expected inflation rate

• Real interest rate

Define the real interest rate?

A savers return on investment after accounting for expected inflation.

What should be the real interest rate if someones goal is to increase savings?

The real interest rate should be positive, greater than 0. The return should exceed the expected inflation rate.

How can the IFE be used to estimate the expected exchange rate movement?

After using nominal interest rates to estimate expected inflation, PPP helps explain how differences in inflation may change exchange rates.

What are the implications of the IFE?

The IFE theory suggests that currencies with high interest rates will have high expected inflation, causing the currencies to depreciate due to PPP.

How does the IFE impact foreign investors?

Foreign investors who attempt to capitalize on high US interest rates will be adversely affected by the effects of a high inflation rate.

How is the IFE applied if the real interest rate is assumed?

As long as the real interest rates are assumed to be the same for the two countries, conclusions should remain the same.

What is the “Imperfect offsetting effect?”

According to the IFE theory, over the course of several periods, the exchange rate effect should fully offset the interest rate advantage.

How is the international fisher effect derived?

It’s the relationship between the interest rate differential (i) between two countries (home country and foreign country) and the expected exchange rate (e).

How to interpret the graphical analysis of the IFE

• The points on the IFE line represent investors who will achieve the same yield whether they invest at home or in a foreign country

• The points below generally reflect higher returns from investing in foreign deposits

• The points above reflect foreign returns that are lower than domestic returns

Briefly explain some limitations of the IFE

• The IFE theory relies on the fisher effect and PPP

• The difference between the nominal interest rate and actual inflation rate is not consistent

Contradictions of the IFE theory

IFE does not always match real-world behaviour, because high interest rates can attract foreign investment. It may work in some countries or time periods, but not in others.

Compare and Contrast the IRP, PPP and IFE

• IRP focuses on why the forward rate differs from the spot rate and the degree of difference to exist

• PPP and IFE focus on how a currency’s spot rate will change over time

• PPP suggests that the spot rate changes due to inflation differentials while IFE suggests it’s due to interest rate differentials

What does S also represent in terms of PPP

The exchange rate

What does So and S1 represent?

The spot exchange rate now and in one year

Why is understanding exchange rate risk for MNC’s?

It’s important for MNC’s to understand how to measure their companies’ exposure to exchange rate fluctuations so they can determine how to protect their operations from that exposure