1. The forward rate at each period forward is higher than the spot which means that the market is
expecting the cd to depreciate throughout the period up to two years.
The cd sells at a 0.2598% forward premium which is approximately how much it is expected to
depreciate over the next year.
Purchasing power parity theoretically states that relative inflation will be accommodated by the an
appropriate change in the exchange rate to exactly compensate to keep prices between the two
countries the same relative to each other.
In calculating PPP one sees that theory expects the cd to appreciate because inflation is higher in the
United States than it is in Canada. However, the market expects the cd to depreciate. Obviously
something else is happening here besides just an inflation adjustment. Of course, over the last year the
cd has appreciated quite substantially and what may be happening is that the market thinks that the cd
is overpriced now and will correct to a more reasonable rate over the course of the next year.
2.
The bid-ask spread represents the profit margin either for commercial bankers (the most important
market makers) or dealers make on foreign exchange. They will buy at the bid and sell at the ask.
For example, at yesterday’s close, U.S. dollars were being purchased at 1.001904 cd and sold at
1.002406 cd by the market makers. On the other side of the market, market makers were buying
Canadian dollars at 0.99759 usd and selling them for 0.9981 usd.
The bid-ask spread prices risk. Consequently, the wider the spread the higher the risk perceived by the
market. That is why forwards will trade at wider spreads than spot, because more time to delivery
makes pricing the forwards more risky. Other factors affecting spread are political risk as represented
by the possibility of new regimes, high budgetary deficit, high BOP deficits, or highly negative
information in the market such as what happened after 911.
3.
The Balance of Payments (BOP) tracks international cash inflows and outflows from Canadians
buying foreign stuff and foreigners buying Canadian stuff. These are official accounts so they only
track legal transactions. These international cash inflows and outflows are segregated into different
accounts so that government policy makers, central bank (CB) policy makers, market makers, and
other financial market professionals have as much information as possible to make accurate
estimates about the exchange rate movements. BOP surpluses will put pressure on a currency to
appreciate and deficits will put pressure on a currency to depreciate.
There are four basic accounts. The trade account tracks primarily sales of goods and services
internationally as well as income generated from foreign investments such as stocks and bonds. The
capital account is a small account which tracks relative flows resulting from transfer of ownership of
foreign assets or such things as debt forgiveness, for example, to countries such as Peru which may have
economic problems. The financial account tracks relative international purchases of both financial
assets and foreign direct investment in real assets. Finally, the foreign exchange account.
The foreign exchange account is that of the CB. The Canadian CB follows a floating exchange rate policy.
Consequently, the purchase or sale of foreign exchange is largely to maintain the liquidity of the
exchange markets for Canadians. While the Canadian CB will not intervene in the exchange market to
affect the trend of the exchange rate; it allows the Canadian dollar (cd) to appreciate even though most
market professionals now consider the cd to be overvalued and hurting Canadian export producers. The
exchange rate is determined by the relative demand and supply for the CD in the exchange markets.
The Canadian CB can and does intervene in the exchange market to reduce volatility. Recently they
have intervened by increasing liquidity (the amount that they were willing to lend overnight to increase
commercial bank reserves) to keep competitive overnight rates in line with the bank rate. The CB has
also been known to defend the usd by buying up excess supply over the short run.
The Chinese CB follows a fixed rate exchange rate policy with respect to the usd. They intervene
constantly to keep the Yuan from appreciating relative to other currencies. They are currently using a
hard peg (a fixed rate), however they are likely in the future to adjust their policy to defend a range of
values (banded float) not a single value. They may also allow the Yuan to appreciate in a controlled
manner over a predetermined schedule (crawling peg). Because the Chinese BOP is in a large surplus,
the Chinese CB must supply Yuan into the exchange markets to satisfy the excess demand for Yuan. In
this process they lose the ability to run their own monetary policy and will suffer excess inflationary
pressures in the future.
4.
When talking about exchange rate dynamics trend illustrates the direction in which the exchange
rate is moving whereas volatility makes a statement about the movement of the exchange rate.
Currently the cd price of the usd is decreasing indicating that the trend of the cd is to appreciate
relative to the usd. Volatility is not extremely high, but there is daily movement in the exchange
rate signifying risk in usd transactions in which payment is in the future.
One can use regression analysis on the exchange rate to determine values for both trend and volatility.
Alpha is the intercept term and beta is the slope (showing trend) for the exchange rate over time. The
regression also calculates the standard error of estimate which is the average deviation of the predicted
exchange rate using the regression equation from the observed value determined in the market in that
time period.
Both a fixed and floating exchange rate system are concerned about volatility. In a floating exchange
rate regime, the CB may intervene in the market if they think that there is too much volatility in the
market. In a fixed exchange rate regime, the CB has primary target to fix the exchange rate such that
trend is zero which effectively eliminates volatility.
5.
In a fixed (managed) exchange regime the CB targets the trend of the exchange rate in some
fashion. It will target trend in three ways: fix the exchange rate, keep the exchange rate within a
specified band (banded peg), allow the exchange rate to revalue on a fixed schedule by fixed
amounts (crawling peg).
A fixed (managed) exchange rate exhibits advantages such as prices with one’s primary customer remain
constant over time, obviously volatility is vastly reduced or eliminated, and hedging costs are reduced or
eliminated. However there are also disadvantages to this system: first the monetary authority loses
complete control of its internal monetary policy, second the government becomes very restricted in its
fiscal policy, third markets are not allowed to adjust international prices so that they converge.
Government fix (manage) their exchange rate policy generally for political reasons such as using it as an
employment policy and ignore sound economic policies. Often this ends in sudden exchange rate
revaluation which plunges the country into chaos (examples of this are the Argentine and Mexican
monetary crises).
In a floating exchange regime, the CB allows markets to determine international prices through almost
instantaneous exchange rate changes. Under such a policy purchasing power parity will be much more
likely to hold.
A floating exchange rate policy has the primary advantage of allowing international prices to converge
toward parity. Governments under a floating exchange rate policy also have complete control of their
own monetary policy which allows them to target domestic policies with policy changes (interest rates,
etc.) It also allows more freedom in the setting of fiscal priorities by the government.
The disadvantages of a floating exchange rate regime lie primarily in that exchange rates are more
volatile which increase hedging costs. Of course, exchange rate trends will always have winners and
losers. With the Canadian economy, appreciation benefits consumers, but disadvantages producers.
Economies which follow a floating rate policy are seeking international price convergence to parity. In
the long run if trade is not restricted by governmental policies, the BOP will automatically converge to
zero as the economies produce only what they have relative advantage (Ricardo) and trade for the
lowest prices possible around the world.
6. Purchasing power parity is a theoretical statement to the effect that the expected future spot will
adjust to account for the effects of relative inflation. From above the calculation gave us the
following result. In this result relative inflation forecast further appreciation in the cd price of the
usd however the forward.
One can make the case that PPP doesn’t hold since the market-determined forward rate is going in a
different direction that the theory-predicted expected future spot.
The Fisher Effect is another theoretical statement relating relative expected inflation to relative
market interest rates.
= 1.0167
Here again, theory doesn’t hold. The relative inflation rates would predict interest rates which
accommodate relative inflation, but they don’t. Even though expected inflation is higher in the U.S.,
interest rates in Canada are higher.
If the parity conditions hold international markets are very efficient. Prices, while conforming to local
variation, on average are converging internationally. Probably the area that most closely approximates
this is the European Union.
If the parity conditions hold approximately, international markets are working relatively efficiently, but
governments are still employing policies such as quotas, tariffs, and subsidies which impede the
convergence of international prices. U.S. and Canadian economies would be examples of this.
If the parity conditions are wildly out of sync it could be a short-run phenomenon in which local market
conditions are overwhelming convergence over the short to medium term (exchange-rate chaos such as
generated in the Argentine or Mexican exchange rate crises are examples of this) or the government has
created an environment of large-scale interference in international markets (OPEC comes to mind as an
example of such large scale interference by fixing oil supplies to change price).