Chapter Five

1
Foreign Exchange Determination

• Chapter Five
• Eiteman, Stonehill, and Moffett

2
Forecasting (fundamental analysis)

• fundamental analysis
• Theoretical analysis
• Purchasing power parity
• balance of payments
• Cash flow analysis
• monetary fiscal policies
• Stock analysis
• regulatory policies
• Trade policies
• political risk

3
Theoretical analysis

• Purchasing power parity
• Assuming efficient markets
• Real world prices converge
• Measurement problems
• Market baskets used to measure inflation are not
  consistent
• Fisher effect
• Interest rate parity

4
Parity conditions
Purchasing Power Parity
Fisher effect
International Fisher effect
Interest rate parity
Unbiased predictor
5
Parity conditions

• For parity to hold
• efficient market conditions needed
• Thick markets
• many buyers, many sellers
• Perfect information
• Low or no market frictions
• Transactions costs
• Taxes, tariffs
• May be most useful pointing to the existence of
  frictions in the market

6
Balance of payments

• Cash flow analysis
• Current acct, capital acct, financial acct,
  reserve acct
• Relative demands and supplies of dollars in the
  exchange markets
• Function of real cash flows to pay for
• Trade in goods, services, transfers
• FDI, investment in real assets
• Portfolio investment, investment in financial
  assets

7
Monetary

• Changes in supply and demand for money
• BOP tracks the foreign exchange as a medium of
  exchange (flow)
• Store of wealth (stock)
• Demand for dollars to hold
• Moderates BOP influences
• China holding dollar assets
• Other currencies are substitutes
• Moving from dollar reserves to euro reserves

8
Central Bank affects on liquidity

• cash currency
• directly supplied by CB
• checking accounts debit cards
• money multiplier determined
• CB directly affects the multiplier
• reserve requirements
• capital requirements
• credit cards
• availability of credit indirectly affected by CB

9
Factors affecting money exchange rates

• economic growth
• economic growth increases demand for base
• inflation
• CB controls the supply of base money
• interest rates
• CB controls the bank rate directly
• CB influences term structure of interest rates
  indirectly
• political risk

10
Economic Growth

• Growth increases the demand for money
• demand for money curve shifts up
• Assume CB keeps money supply constant
• no change in the vertical supply curve
• the value of money increases
• prices and value of money inversely related
• domestically - deflation
• internationally - exchange rate appreciation

11
Money Supply

• Central Bank increases supply of money
• supply curve shifts out
• Assuming no change in demand for money
• the demand for money curve remains stationary
• the value of money decreases
• prices and value of money inversely related
• domestically - inflation
• internationally - exchange rate depreciation

12
Asset market

• Bonds, stocks, currencies are close substitutes
• Changes in demand for financial assets (other
  than money)
• Portfolio diversification
• South American investors
• Saudia Arabian investors
• Capital flight
• Seeking efficient markets
• Properly priced financial assets

13
Term Structure of Interest Rates
iT
New term structure of interest rates after CB
increases bank rate
Term to maturity
14
Shift in Term Structure of Interest Rates

• Central bank changes the bank rate
• only rate directly controlled by CB
• least risky rate in the economy
• no default risk
• little interest rate risk - overnight funds rate
• other rates will ratchet up relative to risk
• default - ability to pay
• interest rate risk - relative to term to
  maturity

15
Jump Shift in Term Structure
iT
Jump in term structure after a large change in
political risk
Term to maturity
16
Jump Shift in Term Structure

• Small change in power structure
• new rules
• some increase in uncertainty about future
• small discrete change in market risk premium
• Large change in power structure
• systemic change in the economy
• large increase in uncertainty about future
• large discrete change in market risk premium

17
Political risk (anticipated)

• Fiscal policies
• taxes, expenditures
• deficit and debt policies
• Monetary policies
• relative inflation, interest rates
• exchange rate (foreign reserves, intervention
• Regulatory policies
• trade restrictions
• capital controls

18
Political risk (unanticipated)

• Political risk
• probability of change in government
• probability of change in direction
• external threats
• crime
• war
• Differences between markets
• official markets
• unofficial markets (grey black markets)

19
Technical Analysis

• technical analysis
• Time series analysis
• trends
• correlation

20
Political Risk

• party in power makes the rules
• distribution of income and wealth
• tax law
• transfers
• regulatory environment
• increase or decrease frims costs of doing
  business
• change of party in power
• change in the rules
• for example PQ in power in Québec

21
Capital Asset Pricing System
iM the market rate increases as the
market becomes more risky
iM - irf the market risk premium also increases
?I measure of risk increases with
market volatility
22
Unsterilized Intervention

• gold
• silver
• cd denominated t-bills
• foreign currency denominated t-bills

• cash
• currency
• chartered bank reserves held at the Bank of
  Canada

Bof C buys US dollars as an asset
Canadian dollar liability increases
23
Domestic Affects of an Unsterilzed Intervention

• Base money increases by amount of purchase
• pressure exerted on prices to increase
• inflation in the economy
• Canadian goods cost more in cd

24
Foreign Affects of anUnsterlized Intervention

• short run
• exchange rate is not allowed to adjust
• long run
• higher Canadian inflation
• US goods cost relatively less to Canadians
• Canadian goods cost relatively more to US
  consumers
• exchange rate remains relatively constant

25
Sterlized Intervention

• gold
• silver
• cd denominated t-bills
• foreign currency denominated t-bills

• cash
• currency
• chartered bank reserves held at the Bank of
  Canada

Bof C buys US dollars as an asset
No increase in B of C liabilities
B of C sells equal value in other assets
26
Domestic Affects of an Sterilzed Intervention

• Base money remains constant
• prices remain constant

27
Foreign Affects of anSterlized Intervention

• short run
• exchange rate is not allowed to adjust
• long run
• pressure remains on exchange rate to depreciate
• BOT deficit remains
• eventually the cd price of the usd will increase

28
BOT (Current Account) Deficit

• currency depreciation
• higher prices for imports
• lower prices for exports
• protectionism
• tariffs, quotas, import restrictions
• capital controls
• restrict foreign ownership
• exchange market intervention

29
Covered Interest Arbitrage

• Borrow 100,000 cd _at_ 6.75
• Buy 66,339.39 usd spot at 1.5074
• Lend 66,339.39 for one year _at_ 7.75
• Buy 107,585.59 cd forward _at_ 1.5051
• collect loan of 71,480.69 usd
• take delivery of forward contract
• pay off loan of 106,750 cd
• riskless return of 835.59 cd