Exchange Rate Determination
With focus on developing a
framework for understanding
changes in spot exchange rates
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.
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
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
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 country’s
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?
Interest Rate Differentials and Exchange
Rates: GBP/USD, 1990 - 2006
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.
Tick by Tick Trades, GBP/USD; September
20, 2010: 4:40 to 4:57pm (FXStreet)
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.
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
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.
Summary of Carry Trade Strategy
Transactions
Factors which result in increasing
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 country’s
exchange rate expected to
appreciate.
– Low interest rate country’s
exchange rate expected to
depreciate.
Factors which result in decreasing
carry trade transactions
• 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 country’s
exchange rate expected to
depreciate.
– Low interest rate country’s
exchange rate expected to
appreciate.
South African Rand and Carry Trades
Background
•
•
On Wednesday, September 22, 2010, South
Africa’s 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.”
USD/ZAR Exchange Rate
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 Tbills 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.
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).
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 market’s aversion
against these riskier financial assets will
generally result in downward pressures on
selected currencies.
The reverse is true when the market’s tolerance
for risk increases.
Risk aversion and risk tolerance relates to
the market’s 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.
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 today’s 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.
Central Bank “Unexpected”
Announcement
Bank of England Raises
Interest Rates
•
•
•
•
•
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.
Reaction of Sterling to the
news (GBP/USD spot rate)
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.
Trade Flow Impacts on Exchange Rates
Deficit Country: Imports > Exports or
Capital Outflows > Capital Inflows
Surplus Country: Exports > Imports or
Capital Inflows > Capital Outflows
Factors Affecting Trade and Capital
Flows
Trade Flows
•
Relative rate of inflation.
– Relatively high rates of inflation lead
to trade deficits (imports > exports)
•
Relative income levels.
– Relatively high income levels leads to
trade deficits (imports > 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.
Capital Flows
• 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 > capital
outflows).
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
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 country’s
external trade imbalance.
• Assume a country’s exchange rate weakens relative to its trading
partners.
• Under this assumption, that country’s goods become cheaper in those
foreign markets and foreign country goods become more expensive.
This factor, everything else equal, should move the country’s 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 B’s consumers can now spend
5% less in their currency to purchase Country B’s goods and services.
– Country B exporters will now find that Country’s A’s 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 A’s exports to Country B should increase
(and/or Country B’s exports to Country A should decrease).
Impact of Exchange Rate Pass
Through on Trade Flows
• What happens in the
real world to a country’s
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.
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.
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 country’s exchange rate and
– (2) short term (perhaps over the course of a day)
moves in a country’s 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).
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 country’s 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
•
• U.S. Central Bank (Federal Reserve):
• New Zealand:
• Australia:
• United Kingdom
• Korea
• China
• Canada
• European Central Bank
• Japan
•
•
Target Rate
Current Rate*
Federal funds rate
0 - .25%
Official cash rate
3.00%
Overnight cash rate
4.50%
Bank rate
0.50%
Base rate
2.00%
Base interest rate
5.13%
Overnight rate
1.00%
Main refinancing rate
1.00%
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/fundamental/interest-rates-table/
Interpreting Central Bank Statements
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.
Market (EUR/USD) Reacts to Possibility of
Return to Quantitative Easing
Long Term Trend Impact of Interest
Rates Changes on Exchange Rate: AUD
Australian Central Bank
Interest Rate Targets
• July 2006:
• August 2006:
• August 2008:
(High point)
• April 2009:
(Low point)
• February 2010:
5.00%
6.00%
7.25%
• September 2010:
4.50%
3.00%
3.75%
Trend and Trend Changes in AUD
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
currency’s spot exchange rate is determined and, as we shall see,
also have a direct impact on the volatility of a currency’s 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).
•
Impact of Foreign Exchange Regime on
Exchange Rates
– (2) Pegged arrangement: This regime sets an exchange rate as determined
by a particular country’s 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
currency’s 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)
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
Impact of Pegged Foreign Exchange
Regime on Currency Volatility
HKD: SD of Monthly % Changes
January 2000 – Sept 2010 = 0.0012%
SAR: SD of Monthly % Changes
January 2000 – Sept 2010 = 0.0011%
0.006
0.006
0.005
0.004
0.004
0.002
0.003
0.002
1
8
15
22
29
36
43
50
57
64
71
78
85
92
99
106
113
120
127
0
0.001
-0.002
1
8
15
22
29
36
43
50
57
64
71
78
85
92
99
106
113
120
127
0
-0.001
-0.004
-0.002
-0.006
-0.003
-0.004
-0.008
Impact of Managed Foreign Exchange
Regime on Currency Volatility
CNY: SD of Monthly % Changes July
2005 – July 2008 = 0.00444%
0.02
SGD: SD of Monthly % Changes
January 2000 – Sept 2010 = 0.0121%
0.04
0.018
0.03
0.016
0.02
0.014
0.012
0.01
0.01
1
7
13
19
25
31
37
43
49
55
61
67
73
79
85
91
97
103
109
115
121
127
0
0.008
-0.01
0.006
0.004
-0.02
0.002
-0.03
0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35
-0.002
-0.04
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%
0.08
0.08
0.06
0.06
0.04
0.04
0.02
0.02
0
0
1
7
13
19
25
31
37
43
49
55
61
67
73
79
85
91
97
103
109
115
121
127
0.1
1
7
13
19
25
31
37
43
49
55
61
67
73
79
85
91
97
103
109
115
121
127
0.1
-0.02
-0.02
-0.04
-0.04
-0.06
-0.06
-0.08
-0.08
Regime Impacts on Currency Volatility:
Summary Table
• Pegged Regimes:
– HKD
– SAR
0.0012%
0.0011%
• Managed Float Regimes
– CNY
– SGD
0.00444%
0.0121%
• Independent Float Regime
– EUR
– GBP
0.02597%
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).
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.
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
who’s 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.
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)
Reason for Strengthening of the Euro
Against the HKD
EUR/USD
USD and HKD Against the EUR
Impact of Peg Regime Changes
Asian Currency Crisis, 1997
Argentina Currency Crisis,
2002