Exchange Rate Determination

1
Exchange Rate Determination

• With focus on developing a framework for
  understanding changes in spot exchange rates

2
Review of Spot Quote

• Go to http//www.fxstreet.com/
• Link to Rates and Charts then to Live Currency
  Rates then link to any quoted pair. Observe the
  bid and ask prices for this currency pair.
• Examine changes in spot rate from standpoint of
  non-market maker wanting to buy and hold a
  currency (e.g., euro).
• Link to Live Streaming Forex Charts. Link to
  Ticks time scale.
• Tick data is the intra-day data stream that
  records each market transaction (buy or sell) in
  the market.
• Observe how quickly spot rates move.

3
Observing Moves in Spot Rates

• Go to
• http//www.fxstreet.com/
• Link to Live Streaming Forex Charts.
• Observe Candle-Stick chart type (with time
  scale 1 minute).
• Review meaning of Candle-Stick presentation.
• When close is higher than the open (indicated by
  green on FX street) bullish signal
• When close is lower than the open (indicated by
  red on FX street) bearish signal

4
What Determines the Spot Exchange Rate and Causes
it to Change?

• Demand and Supply Model of Exchange Rates
• One approach to the analysis of a possible
  exchange rate change is through the use of demand
  and supply models (from macro-economics).
• Demand and/or supply shifts will cause the spot
  (equilibrium) rate to change.
• This is an approach which is best applied to
  explain floating exchange rates and to perhaps a
  lesser degree managed rates.

• Supply
• FX
• Rate
• Demand
• Quantity of FX

5
Asset Choice Model

• Asset Choice Question Why do financial markets
  prefer to hold one currency over another
  currency?
• One Important Factor Short term returns which
  can be earned when investing in relatively "risk
  free financial assets in each countrys
  financial markets.
•  
• Example (September 14, 2010 data)
• Australia 4.66 on 3-month T-bills
• United States 0.14 on 3-month T-bills
• Analysis Looking at these interest
  differentials, which currency will global
  investors prefer and what will be the impact on
  the exchange rate between the two currencies?

6
Interest Rate Differentials and Exchange Rates
GBP/USD, 1990 - 2006
7
FX Trading Terminology

• GBP/USD Currency pair referred to as the
  cable rate.
• PIP Forex prices are often quoted in tiny
  increments called pips. A pip refers to the
  fourth decimal point. Except for the Japanese
  yen, where pips refer to the second decimal point
  (This is the only exception among the major
  currencies).
• EUR/USD 1.2550 to 1.2552 a change of 2 pips.
• USD/JPY bid 85.40 ask 85.44 a spread of 4
  pips.
• Tick Consecutive trades and the prices for those
  consecutive trades.
• GBP/USD First tick 1.5501 second tick (trade)
  1.5503 etc
• Long position Buying a currency and holding it
  for some period of time in anticipation of the
  currency strengthening.
• Profit if currency appreciates.
• Short position Selling a currency in
  anticipation of the currency weakening. When it
  does, buying it back (covering the short
  position).
• Profit if currency weakens.

8
Tick by Tick Trades, GBP/USD September 20, 2010
440 to 457pm (FXStreet)
9
Carry Trade Strategies

• Definition A Carry Trade strategy is a foreign
  exchange trading strategy which aims to take
  advantage of both low interest rate and high
  interest rate countries. Carry trade strategies
  are used by hedge funds and other traders to take
  advantage of interest rate differentials. A
  carry trade strategy involves the following
  steps
•  
• Borrowing funds from commercial banks in a low
  interest rate country. These are short term
  loans and liabilities in the currency of the low
  interest rate country.
• Converting the borrowed money into the currency
  of the country with the high interest rate.
• Investing these funds into short term safe
  financial assets of the high interest rate
  country. These are short term financial assets
  denominated in the currency of the high interest
  rate country.

10
Carry Trade Strategy Impacts on Exchange Rates

• Low Interest Rate Country When its Currency is
  Sold in the Forex Market

• High Interest Rate Country When its
• Currency is Bought in the Forex Market

11
Risk with Carry Trade Strategies

• Liability Risk

• Financial Asset Risk

• Carry trade strategist has a liability (i.e., a
  bank loan) denominated in the currency of the low
  interest rate country.
• Risks
• The interest rate might increase (problem if it
  is a floating rate loan).
• Thus, increasing the nominal interest rate on the
  loan.
• The currency of the low interest rate country may
  strengthen.
• Thus, increasing the exchange rate adjusted cost.

• Carry trade strategist has an asset (i.e., a
  T-bill) denominated in the currency of the high
  interest rate country.
• Risks
• Reinvestment-Risk Interest rates might fall and
  thus when maturing securities are reinvested they
  result in lower returns.
• Price-Risk Interest rate might increase and thus
  the market price of the T-bill will fall (recall
  the inverse relationship between interest rates
  and bond prices, resulting in a capital loss on
  the bond.
• Note of the two risk above, reinvestment risk
  is probably the most critical, as most
  investments are in short term securities and thus
  the price risk is minimal.
• The currency of the high interest rate country
  may weaken.
• Thus, reducing the exchange rate adjusted return.

12
Summary of Carry Trade Strategy Transactions

• Factors which result in increasing carry trade
  transactions

• Factors which result in decreasing carry trade
  transactions

• An increase in the interest rate differential
  between the two carry trade countries, due to
• Higher interest rates in the high interest rate
  country.
• Lower interest rates in the low interest rate
  country.
• Expectation regarding exchange rates
• High interest rate countrys exchange rate
  expected to appreciate.
• Low interest rate countrys exchange rate
  expected to depreciate.

• A reduction in the interest rate differential
  between the two carry trade countries, due to
• Lower interest rates in the high interest rate
  country (i.e., the reinvestment risk).
• Higher interest rates in the low interest rate
  country.
• Expectation regarding exchange rates
• High interest rate countrys exchange rate
  expected to depreciate.
• Low interest rate countrys exchange rate
  expected to appreciate.

13
South African Rand and Carry Trades

• Background

• USD/ZAR Exchange Rate

• On Wednesday, September 22, 2010, South Africas
  rand rallied to more than 2 1/2-year high against
  the US dollar, at 6.9815. As shown in the chart
  to the right, the rand appreciated sharply in
  2009 and has recently showed renewed strength.
• Carry Trades In January 2009, the South African
  Central Bank benchmark rate stood at 11.5 (U.S.
  rate at 0.0 to 0.25). Since that time the South
  African Central Bank as gradually lowered its
  rate (currently at 6.5), but the rate
  differential still favors the rand.
• According to Julian Wilson, a trader at Citigroup
  Inc. in Johannesburg The dollar has lost a lot
  of ground. U.S. interest rates are going to be
  kept lower for much longer, which maintains the
  interest differential between higher-yield assets
  and those denominated in dollars.
• Thus, the near-zero interest rates in developed
  markets have encouraged investors to borrow in
  these markets and invest in higher- yielding,
  emerging markets such as South Africa.
• According to Bloomberg, The transactions, known
  as carry trades, have swelled net foreign
  purchases of South African assets to 100.8
  billion rand (14.4 billion) this year.

14
Safe Haven Financial Assets and Safe Haven Effects

• Definition of a Safe Haven Financial Asset A
  financial asset or commodity (usually gold) that
  is favored by investors in times of a global or
  regional crisis.
• Financial assets are generally short term and
  risk free (i.e., government T-bills or bank
  deposits)
• The United States, Japan and Switzerland are
  regarded today as the three primary safe haven
  countries.
• Safe Haven Effect For global investors in
  park funds in safe haven assets they must first
  purchase the currency of the safe haven country.
  This will produce upward pressure on the safe
  haven currency.

15
Flight to Safety First Gulf War

• Safe Haven Effect Into the Swiss Franc (CHF)
  during the early stages of the 1990 Gulf War
• August 2, 1990 Iraq Invades Kuwait
• August 7, 1990 US forces arrive in Saudi Arabia
• Percent Change in CHF against the USD
  approximately 10 (mid July Late Aug).

16
Changes in the Global Markets Aversion for or
Tolerance of Risk

• A safe haven effect with specific focus on risk
  aversion and risk tolerance.
• This effect simply relates to the demand shift
  away from risky asset classes (e.g., stocks or
  low grade bonds) to less risky asset classes
  (e.g., high grade government securities). Factors
  which increase the global markets aversion
  against these riskier financial assets will
  generally result in downward pressures on
  selected currencies.
• The reverse is true when the markets tolerance
  for risk increases.
• Risk aversion and risk tolerance relates to the
  markets assessment and outlook for key global
  economies.
• Relates to incoming financial and economic data
  which is not in line with market expectations for
  that data.

17
News Which Impacts Favorably/Unfavorably on
Countries and Their Prospects (i.e., the
Efficient Market Response)

• Efficient market hypothesis (EMH) is an idea
  developed in the 1960s by Eugene Fama of the
  University of Chicago that essentially says that
  if financial markets are efficient, then prices
  of financial assets (such as the spot foreign
  exchange rate for a currency) will reflect and
  incorporate in their prices all relevant
  economic, financial, political (etc) information.
  
• Essentially, if financial markets are
  informational efficient then an asset price
  reflect what is known by market participants
  about the past, the present, and what is expected
  to happen in the future.
• Expectations then play a role in todays asset
  prices, i.e., spot exchange rates. If we assume
  this is true, then exchange rates will only
  respond to unexpected news or unexpected
  events.
• Why? Because expected news and expected events
  have already been incorporated in the current
  spot exchange rate.
•  

18
Central Bank Unexpected Announcement

• Bank of England Raises Interest Rates

• Reaction of Sterling to the news (GBP/USD spot
  rate)

• On Thursday, January 11, 2007, the Bank of
  England surprised financial markets by raising
  their key monetary policy interest rate by 25
  basis points to 5.25. The Bank of England
  announced in raising the rate the U.K. "The
  margin of spare capacity in the economy appears
  limited, adding to domestic pricing pressure.
  (i.e., inflation).
• Only one of the 50 analysts polled by Reuters had
  predicted the move, which took borrowing costs to
  their highest level in 5-1/2 years.
• Most had thought the central bank would wait at
  least another month to see whether wages were
  heading up in the New Year and for a clearer
  reading on the consumer sector.
• The pound rose dramatically as analysts were
  caught off guard and said markets were on
  heightened alert for more moves in the future.
• "We're rethinking our interest rate forecasts.
  The MPC has surprised financial markets twice now
  within the space of six months and at this
  juncture it's impossible to rule out another
  surprise," said Philip Shaw, chief economist at
  Investec.

19
Trade Flows Between Countries

• Trade flows, and any resulting trade imbalances,
  between countries can have an effect on exchange
  rates. The issue with this factor, however, is
  that the cause effect relationship can work
  both ways, i.e., trade flows affecting the
  exchange rate and in turn the exchange rate
  affecting trade flows.
•  Measure of trade flows
• Merchandise trade flows Refers to exports and
  imports of merchandise goods. We can also add
  service flows.
• Capital account trade flows Refers to cross
  border buying of both financial and real assets.

20
Trade Flow Impacts on Exchange Rates

• Deficit Country Imports gt Exports or Capital
  Outflows gt Capital Inflows

• Surplus Country Exports gt Imports or Capital
  Inflows gt Capital Outflows

21
Factors Affecting Trade and Capital Flows

• Trade Flows

• Capital Flows

• Relative rate of inflation.
• Relatively high rates of inflation lead to trade
  deficits (imports gt exports)
• Relative income levels.
• Relatively high income levels leads to trade
  deficits (imports gt exports).
• Government policies including
• Tariffs and quotas.
• Management of exchange rate if a country
  undervalues its currency, this can lead to a
  trade surplus (e.g., China today?)
• Product characteristics and demand.
• Product substitutes, monopoly suppliers.

• Relative real returns on financial assets, where
  the real return is the nominal return minus
  inflation.
• Relative real interest rates.
• Relative real returns on stocks.
• Relatively high real returns lead to net capital
  inflows (capital inflows gt capital outflows).

22
Exchange Rates and Real Interest Rates

• Data (1980 1986)
• (1) Exchange Rate Index of USD against 10 major
  trading partners
• (2)Real Interest Rate Differential Long Term
  U.S. Real Interest Rate minus a Weighted Average
  of 10 Foreign Long Term Real Interest Rates
• Source Federal Reserve of Kansas City Study,
  November 1986

23
Impact of Exchange Rate Changes on Trade Flows

• Under a floating rate exchange rate system,
  changes in the exchange rate are assuming to have
  a lagged effect on a countrys external trade
  imbalance.
• Assume a countrys exchange rate weakens relative
  to its trading partners.
• Under this assumption, that countrys goods
  become cheaper in those foreign markets and
  foreign country goods become more expensive.
  This factor, everything else equal, should move
  the countrys trade in the direction of a surplus
  (or greater surplus) as it exports more and
  imports less. Why do we assume this?
• Assume currency A weakens by 5 against currency
  B (i.e., currency B has strengthened by 5
  against currency A).
• Country A exporters will now find that Country
  Bs consumers can now spend 5 less in their
  currency to purchase Country Bs goods and
  services.
• Country B exporters will now find that Countrys
  As consumers will need to spend 5 more in their
  currency to purchase Country B goods and services
  (at Country B prices)
• Thus, everything else equal, Country As exports
  to Country B should increase (and/or Country Bs
  exports to Country A should decrease).

24
Impact of Exchange Rate Pass Through on Trade
Flows

• What happens in the real world to a countrys
  trade balance (exports and imports) depends upon
• The response of global companies to the exchange
  rate change and their foreign market currency
  pricing strategy.

• Assume the following
• Country B Exporter (a US company) selling a
  product in Country A (Japan) at a local selling
  price of 10,000 yen.
• Assume the initial exchange rate (USD/JPY) is
  100 thus the return to the U.S. exporter in USD
  is 100.
• Now assume the yen weakens by 5 to 105.
• At this new exchange rate, the U.S. exporter will
  have to raise prices to 10,500 yen to maintain
  the 100 return.
• However, Country B Exporter (the US company) may
  decide to
• (1) Keep their Currency A selling price unchanged
  at 10,000 and thus absorb the entire negative
  exchange rate effect. This is called a full
  pass through of the exchange rate and should
  result in no change in the demand for these
  goods.
• (2) Raise their Currency A selling price less
  than 5. This should result in less change in
  the demand for these goods.

25
Exchange Rates and Trade Balances A Complete
Picture

• Data from 2002 to 2008, shows a pattern in which
  periods of CAD appreciation alternate with
  periods where the trade balance increases.
• When the trade balance is high, the CAD
  appreciates (see ).
• This may represent the impact of the trade
  balance on the currency.
• However, the appreciation eventually brings the
  trade balance down (see ).
• This may represent the impact of the exchange
  rate on the trade balance.

26
Central Bank Decisions and Announcements

• Central Bank announcements and decisions,
  especially as these relative to interest rate
  target changes, can have substantial impacts on
• (1) the trend of a countrys exchange rate and
• (2) short term (perhaps over the course of a day)
  moves in a countrys exchange rate.
• As noted earlier, interest rate impacts can be
  viewed in terms of the asset choice model or, if
  unexpected changes, in terms efficient market
  effects (e.g., see Bank of England, January 11,
  2007 announcement).

27
What Central Bank Interest Rates Should We
Follow?

• While some central banks use a variety of
  interest rates depending upon the use of that
  rate, all have a short term target rate. This
  target rate is what each central bank uses to
  affect its countrys financial system, and hence
  overall economic activity. All of these target
  rates have specific names as designated by each
  central bank. For the major central banks, these
  target rates are as follows
•  Central Bank Target Rate
  Current Rate
•  
• U.S. Central Bank (Federal Reserve) Federal
  funds rate 0 - .25
• New Zealand Official cash rate 3.00
• Australia Overnight cash rate 4.50
• United Kingdom Bank rate 0.50
• Korea Base rate 2.00
• China Base interest rate 5.13
• Canada Overnight rate 1.00
• European Central Bank Main refinancing rate
  1.00
• Japan Uncollateralized overnight call rate
  0.10
• Rates as of September 14, 2010
• For current and historical central bank rates and
  changes link to http//www.fxstreet.com/fundament
  al/interest-rates-table/

28
Interpreting Central Bank Statements

• Market (EUR/USD) Reacts to Possibility of Return
  to Quantitative Easing

• FOMC Press Release September 21, 2010

• Information received since the Federal Open
  Market Committee met in August indicates that the
  pace of recovery in output and employment has
  slowed in recent months. Household spending is
  increasing gradually, but remains constrained by
  high unemployment, modest income growth, lower
  housing wealth, and tight credit. Business
  spending on equipment and software is rising,
  though less rapidly than earlier in the year,
  while investment in nonresidential structures
  continues to be weak.
• The Committee will maintain the target range for
  the federal funds rate at 0 to 1/4 percent and
  continues to anticipate that economic conditions,
  including low rates of resource utilization,
  subdued inflation trends, and stable inflation
  expectations, are likely to warrant exceptionally
  low levels for the federal funds rate for an
  extended period.
• The Committee will continue to monitor the
  economic outlook and financial developments and
  is prepared to provide additional accommodation
  if needed to support the economic recovery.
• Interpretation The central bank did not
  announce further quantitative easing but warned
  that is prepared to provide additional
  accommodation if needed.

29
Long Term Trend Impact of Interest Rates Changes
on Exchange Rate AUD

• Trend and Trend Changes in AUD

• Australian Central Bank Interest Rate Targets

• July 2006 5.00
• August 2006 6.00
• August 2008 7.25 (High point)
• April 2009 3.00 (Low point)
• February 2010 3.75
• September 2010 4.50 

30
Impact of Foreign Exchange Regime on Exchange
Rates

• As we noted in an earlier lecture, countries use
  three types of foreign currency regimes. These
  regimes influence how a currencys spot exchange
  rate is determined and, as we shall see, also
  have a direct impact on the volatility of a
  currencys spot exchange rate. As a quick
  review, these three regimes are
• (1) Independent float (also called a freely
  floating regime) This regime allows the private
  market, through demand and supply shifts, to set
  the exchange rate. Under this regime, the
  private market is constantly adjusting the
  exchange rates as new information comes into the
  market. What we have examined thus far in this
  lecture are essentially factors to consider under
  an independent float regime.
• Examples of Independent floating currencies (and
  year adopted) Canadian dollar (1970), U.S.
  dollar (1973), British pound (1973), yen (1973),
  Australian dollar (1985), New Zealand dollar
  (1985), Euro (1999), Argentina Peso (2002).
•  

31
Impact of Foreign Exchange Regime on Exchange
Rates

• (2) Pegged arrangement This regime sets an
  exchange rate as determined by a particular
  countrys government. The exchange rate is
  allowed to vary within a very small range of the
  peg as demand and supply conditions change. The
  government is committed to intervening in foreign
  exchange markets to prevent the currency from
  moving outside of its peg range. The currency is
  not allowed to appreciate or depreciation over
  time, but instead moves with the range of this
  peg. The peg is set in relation to a major
  currency (e.g., the USD) or a basket of
  currencies.
• Example of Pegged currency Hong Kong dollar,
  since 1983 (7.8HKD 1USD)
• (3) Managed float In between an independent
  float and a pegged arrangement is a managed
  float, whereby a government will manage its
  currencys exchange rate as the private market
  pushes it one way or the other. Under this
  arrangement, a currency can still appreciate or
  depreciate over time, but the daily movement will
  be managed by the government though intervention.
• Examples of Managed float currencies Singapore
  dollar, Egyptian pound, Israel shekel, Indian
  rupee, Chinese Yuan (July 2005 July 2008 Early
  2010 to the present)
•  
•  

32
Measure of Currency Volatility

• Standard deviation Is a measure of the
  dispersion or variation in a set of data from the
  average measure of that data. The greater the
  standard deviation, the greater the volatility of
  the data you are looking at. Greater volatility
  also means greater risk.
• See two examples to the right, Assume both have
  means of 0 (average percent change).
• Note the first example, with its larger spread
  about the mean, has a greater standard deviation,
  hence greater volatility.
• For reasonably symmetric and bell shaped data
  sets we can assume
•   /- 1 standard deviation contains roughly 68
  of the data
• /- 2 standard deviations contains roughly 95
  of the data
• /- 3 standard deviations contains roughly all
  the data

33
Impact of Pegged Foreign Exchange Regime on
Currency Volatility

• SAR SD of Monthly Changes January 2000 Sept
  2010 0.0011

• HKD SD of Monthly Changes January 2000 Sept
  2010 0.0012

34
Impact of Managed Foreign Exchange Regime on
Currency Volatility

• CNY SD of Monthly Changes July 2005 July
  2008 0.00444

• SGD SD of Monthly Changes January 2000 Sept
  2010 0.0121

35
Impact of Floating Foreign Exchange Regime on
Currency Volatility

• EUR SD of Monthly Changes January 2000 Sept
  2010 0.02597

• GBP SD of Monthly Changes January 2000 Sept
  2010 0.02373

36
Regime Impacts on Currency Volatility Summary
Table

• Pegged Regimes
• HKD 0.0012
• SAR 0.0011
• Managed Float Regimes
• CNY 0.00444
• SGD 0.0121
• Independent Float Regime
• EUR 0.02597
• GBP 0.02373
• Note All standard deviations against the USD
  Monthly percentage change data January 2000 to
  September 2010 (except for the CNY, July 2005 to
  July 2008).

37
Implications of Regimes for Global Companies and
Global Investors

• As we have noted, global companies and global
  investors face exchange rate exposures and
  exchange rate risk.
• The risk that the exchange rate may move against
  the firm or the investors.
• The exchange rate regime will, in part, determine
  the degree of that risk that the firm and
  investor faces.
• Risk as measured by the potential volatility of
  the foreign currency the firm or investor is
  exposed to.
• Floating rate regimes pose the greatest potential
  risk (i.e., greater potential volatility) while
  pegged regimes the least risk. Managed floats
  fall in the middle.

38
Problem with Pegged Regimes

• As long as the country maintains its pegged
  regime, the global firm and global investor is
  shielded from exchange rate risk.
• This is only true for those firms and investors
  whos home currency is the peg-tie in.
• However, peg regimes can change and when they do
  the exchange rates associated with them change
  quickly.
• This is referred to as regime change risk.

39
Hong Kong Dollar Peg

• The Peg Against the USD (set at 7.8 in 1983)

• HKD Weakened Against the EUR (not part of the peg)

40
Reason for Strengthening of the Euro Against the
HKD

• EUR/USD

• USD and HKD Against the EUR

41
Impact of Peg Regime Changes

• Asian Currency Crisis, 1997

• Argentina Currency Crisis, 2002