Econ 1

Front 1

Spot exchange rate for immediate delievery(usually 2 days after trade)

Fwd exchange rate is currency exchange in the future with various dates

Back 1

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Front 2

Dealer quotes can include both bid and offer

Eg

Euro could be quoted as $1.41 - 1.42

The bid 1.41 is price dealer will buy euros and the offer 1.42 is price they will sell euros

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Front 3

Diff between bid and offer(ask) is spread often stated as pips

$.0004 is 4 pips so 1/10,000

Which is dealers profit

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Dealers manage foreign currency inventories in interbank market where spreads are narrow

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Spreads quoted by dealers depends on

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1. Interbank spread

2 size of transaction

3 relationahip with client**better credit risk better spread

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Interbank spread depends on

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1. Currencies involved- high volume pairs have lower spreads ie USD/EUR

2. Time of day*london open not best cause all markets not open then usually 8-11am NY time

3. Market vol of currencies invlolved

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Spreads increase with contract maturity as they become less liquid and interest rate risk increases with maturity

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Front 8

Usd/Aud of 1.05 / 1.06

Investors can buy AUD for $1.05 or sell at $1.06

Rule is buy the base at ask or sell the base at bid

For price:

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Sell price at ask and buy price at bid/offer

Front 9

Up the bid Multiply

Down the ask Divide rule

For USD/Aud if want to convert USD to Aud you are going down the quote(usd to aud):

Back 9

Use ask price

Front 10

If want to convert Aud to USD use

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Bid price

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Aud/Gbp of 1.506 - 1.5066

Compute proceeds of converting 1mm GBP

Compute proceeds of converting 1mm Aud

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1mm Gbp * 1.506= 1.506mm Aud

1mm Aud / 1.5067= 663,702 GBP

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Cross rate

Back 12

exchange rate between 2 currencies based on their rates with a common 3rd currency

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Usd/Aud =.6

Mxn/Usd= 10.7

What is cross rate btween Aud and MXN

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.6*10.7=6.42. Is pesos to Aud

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triangular arbitrage

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If dealer has bid ask quotes too low youncan buy and sell with 3 different currencies to gain profit

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Currencies quoted at fwd premium if

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Fwd price is greater than spot

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Currencies at fwd doscount if

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Fwd less than spot

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Premium or discount is for base currency

If Usd/Eur is 1.2 for spot and 1.25 for fwd it is...

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A fwd premium for the Euro caue the euro(base) buys more usd in future

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Spot 1.0511/1.0519

30day +3.1/+4.1

What is 30 day fwd

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Add .00031(4 zeros ir divide by 10,000)

Add .00041

1.05149/1.05231

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For an investor wishing to convert must use all in rate which is the ask rate which is the spot plus the fwd premium

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Value of fwd contract prior to expiration is mark to market=

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(New fwd of price currency - purchased fw price of price currency) * contract / (1+ rate of price *(days remaining/360)

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Covered interest parity holds when any fwd premium or discount offsets differences in interest rates and invester would earn same return in either currency...so if euro interest rates higher than Usd than depreciation of eruo to Usd will need to offset this

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Covered Interest rate parity

Fwd rate=

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Spot B*

(1+ currency A rate *(days/360)) /

(1+ currency B rate *(days/360))

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Uncovered interest rate parity

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Fwd currency contracts or capital inflows restricted so as to prevent arbitrage...ie NOT bound by arbitrage

Rate A-rateB

Front 24

Find expected percent change in exchange rate using uncovered parity

Zar/Euro 8.385. 1yr nominal eurozone is 10% and 1yr South africa 8%.

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8-10=-2% so euro will depreciate by 2% from 8.385*.98= to 8.217

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**Covered interest rate parity derives nonarbitrage FWD rate

Uncovered derives expected future SPOT rate

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With uncovered if foreign rate is 2% higher its assumed the foreign currency is 2% lower so investor is risk nuetral

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Unbiased predictor

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If fwd rate is equal to expected future spot rate or fwd rate parity..and covered and uncovered rate parity will hold

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Fisher relation

Rate of return Nominal=

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Real rate + inflation

*use EXpected inflation if International

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Real interest rate parity

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Rates converge across different markets

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International fisher effect

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Nominal rate A - nominal rate B = expected inflation A - exp inflation B

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Law of one states identical goods should have same price in all locations but tariffs and shipping etc makes this not hold

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Absolute purchasing power parity

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Avg price of a basket of goods between countries

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S ab= CPIa /CPIb

In practice law of one might not hold due to demand in for diff products in diff countries

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Relative PPP

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Changes in exchange rates should offset inflation differences between countries

So if As inflation was 6% and Bs 4%. As currency should depreciate 2% to Bs

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Relative PPP equation

Change in spot price

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Inflation A - inflation B

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Ex ante ppp

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Same as relative but uses expected inflation

Front 37

Spot Usd /Aud is 1. Aus inflation expected to be 5%. And Us is 2%. What is change in spot

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2-5= -3

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If uk short term rates are 3%

And US has 1%

Uncovered interest rate parity states

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GBP should depreciate 2% realtive to USD

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However interest rate parity is NOT bound by arbitrage

So if GBP depreciates less than 2% if an investor is in a higher yielding GBP using funds borrowed in USD will earn profit

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Fx carry trade

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Invest in higher yielding currency using funds borrowed in a lower yieldong currency

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Carry trade return

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Interest earned - funding cost(lower currency) - currency depreciation

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Sometimes the higher yield attracts more inflows and currency appreciates so investor earns on higher yield and appreciation

But if funding curremcy appreciates you could lose

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Front 43

Crash risk

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Due to negative skewness and excess hurtosis (fat tails) the prob of a large loss is higher than prob under normal distribution

This is due to the herding nature...while more people may buy higher yielding currency and it appreciates the currency they may also try to exit at once as well

Front 44

Balance of payment

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All payments and liabilites to and from foreigners

Includes gov, consumer and biz transaction

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Current

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Measures exchange of goods, services, investment INcome, unilateral transfers(gifts from a nation to other)

Tells if we are buying more goods and services from world than selling to them

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Financial account or capital account

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Flow of debt and equity into or out of country

Front 47

If current account is at defitict must generate surplus of capital account.

Capital flows dominate exchange rate in short term as they are larger and more rapidly chaning than goods flow

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Front 48

Current account deficits lead to currency depreciation

Back 48

Increase the currency in the market as the exporters had to convert back to their currency.

Thus decrease may restore current deficit to balance.

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1.Flow supply/demand

Increase the currency in the market as the exporters had to convert back to their currency.This decrease may restore current deficit to balance.

Depending on 3 factors

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1 size of Inititial deficit

2 influence of exchange rates on import/export prices- as a currency depreciates imports are more expensive but not all cost may be passed to customer

3. Price elasticity of goods - if price inelastic the quantity of imports wont change

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(Cont) Reasons for why current deficit cause currency depreciation

2.portfolio balance

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Current surplus countries usually have capital deficits and vice versa

When the investor rebalances investment portfolios can have big impact on investee currency

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3. Debt substainability

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When running a current deficit mayhave capital surplus from high debt. When gets to high to GDP investors may scare causing rapid deprecation

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Capital flows increase then currency increases/appreciates. If higher rates higher flows.

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Capital flows may be needed to cover shortfall of internal savings.

Capital flows in excess of investment causes several problems:

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Excessive appreciation of currency

Financiall or RE asset bubble

Increases in external debt

Excessive consumption fueled by credit

Front 54

Mundell fleming model. Evaluates impact on monetary and fiscal policies on interest and then exchange rates

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Assumes sufficient slack in economy to handle demand

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Flexible/floating midel

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Rates go off supply and demand in foreign markets

Front 56

Expansionary fiscal and monetary policy likely will have opposite effects on exchange rates.;

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Expansionary monetary reduces interest rates which reduces inflow of capital investments.

This decrease reduces demand for domestic currency.

Expansionary fiscal(lower taxes increased gov spending) increases borrowing AND interest rates at same time. Higher interest rates attracts foreign investment AND demand for that currency

Front 57

Last slide assumes fre capital flow

In EM may not be the case. In which case impact of trade imbalance on exchange rates in greater than impact from interest rates.

Expansionary policy leads to increased imports and depreciation of currency.

Restrictive monetary policy leads to gain on domestic currency

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Under mundell fleming higher rate currency appreciates. While in interest rate parity it depreciates due to it assumes that real rates are equal globally and then nominal rates imply mirror inflation. But mundell doesnt consider inflation

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In a fixed rate regime expansionary will lead to depreciation. Which would make gov then have to purchase its own currency on thebforeign exchanges which defeats purpose of expansionary measures in first place

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Monetary models dont consider fiscal policies

Two main monetary approaches

1. Pure monetary model

2. Dornbusch overshooting model

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1. Ppp holds constant. Expansionary leads to increase in prices and decrease in currency value.

2. Prices are sticky in shirt term and dont change right away. Says exchange rates will overshoot long run PPP in the short term.

*short term excessive currency appreciation and slow depreciation to long term PPP

Prices increase but over time. Expansionary lead to a decrease in interest rates and a larger than implied PPP depreciation of currency due to cap outflows but go towards implied PPP long term

Front 61

Portfolio balance focuses on LONG term fiscal policies.

Since investor of currency gains on yield of debt and its currency return they base decisions on risk return and running long term deficits might lower investors willingness to fund debt.

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Combining mundell and fleming shows in short term expansionary Fiscal policy leads to currency appreciation. But depreciation long term c

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Pull factors for flow of capital

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Price stability

Flexible exchange rate regime

Imoroved fiscal position

Privatization of state owned

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Push factors

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Intl capital seeking high returns from diversified portfolio

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Objectives of capital controls or central bank on FX markets are to

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Ensure domestic currency doesnt appreciate too much

-allow independent monetary policy w/o currency values hindering

- reduce aggreagate inflow of foreign capital

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Developed countries central bank reserves arent high enough to change FX rates

EM it is unclear some may be able to accumulate enough

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Foreign Direct Investment FDI

Back 67

Buying property, plant, equipment

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Indirect investment

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Equity or fixed income