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Currency Exchange Rates  Real exchange rate: the focus shifts from the quotations in the foreign exchange market to what the currencies actually purchase in terms of real goods and ser

2017CFA二级培训项目

Economics

讲师：单晨玮

Topic Weightings in CFA Level II

Study Session 1-2 Ethics & Professional Standards 10-15

Study Session 4 Economic Analysis 5-10

Study Session 5-6 Financial Statement Analysis 15-20

Study Session 12-13 Fixed Income Analysis 10-20

Framework

Economic Analysis

SS4 Economics for Valuation

1 R13 Currency exchange rate: determination and forecasting

2 R14 Economic Growth and investment decision

3 R15 Economics of Regulation

Reading

13 Currency exchange rate: determination and forecasting

Currency Exchange Rates

 Real exchange rate: the focus shifts from the quotations in the foreign

exchange market to what the currencies actually purchase in terms of real goods and services

 FX real(d/f) = FX nominal (d/f) *CPIf/CPId

 Changes in real exchange rates can be used when analyzing economic changes over time

 When the real exchange rate (d/f) increases, exports of goods and services have gotten relatively less expensive to foreigners, and imports of goods and services from the foreign country have gotten relatively more expensive over time

 Example: At a base period, the CPIs of the U.S and U.K are both 100,

and the exchange rate is $1.70 per euro Three years later, the exchange rate is $1.60 per euro, and the CPI has risen to 110 in the U.S and 112

in the U.K What is the real exchange rate?

 Solution: The real exchange rate is $1.60 per euro * 112/110 = $1.629

per euro

Currency Exchange Rates

Currency Exchange Rates

Warm-up: FX Appreciation and Depreciation

 Example: the dollar-Swiss franc rate increase from USD: CHF = 1.7799

to 1.8100 The Swiss franc has depreciated relative to the dollar– it now takes more Swiss francs to buy a dollar

 An increase in the numerical value of the exchange rate means that the base currency has appreciated and that the price currency depreciated

 1.7799CHF/USD to 1.8100CHF/USD

 USD appreciated therefore CHF depreciated

Spot Rate And Forward Rate

 Spot rates are exchange rates for immediate delivery of the currency

 Spot markets refer to transactions that call for immediate delivery of

the currency In practice, the settlement period is two business days after the trade date

 Forward rates are exchange rates for currency transactions that will occur in

the future

 Forward markets are for an exchange of currencies that will occur in

the futures Both parties to the transaction agree to exchange one currency for another at a specific future date

Bid-Ask Spread

 The spread on a foreign currency quotation

 The bid price is smaller and listed first It is the price the bank/dealer will pay per FC unit

 The ask price is higher and always listed second It is the price at which the bank will sell a unit of FC

 The difference between the offer and bid price is called the spread

Spreads are often stated as ‘pips’

 Example: the euro could be quoted as $1.4124-1.4128 The spread is

$0.0004 (4 pips)

 The spread on a forward foreign currency quotation

 Consider a 6-month (180 days) forward exchange rate quote from a U.S currency dealer of GBP:USD = 1.6384 / 1.6407

spread = (1.6407 – 1.6384) = 0.0023 (23 pips)

Bid-Ask Spread

 The spread quoted by the dealer depends on：

 The spread in the interbank market for the same currency pair Dealer spreads vary directly with spreads quoted in the interbank market

 The size of the transaction Larger, liquidity-demanding transactions generally get quoted a larger spread

 The relationship between the dealer and client Sometimes dealers will give favorable rates to preferred clients based on other ongoing

business relationships

Bid-Ask Spread

 The interbank spread on a currency pair depends on：

 Currencies involved Similar to stocks, high-volume currency pairs (e.g., USD/EUR, USD/JPY, and USD/GBP) command lower spreads than do lower-volume currency pairs (e.g., AUD/CAD)

 Time of day The time overlap during the trading day when both the New York and London currency markets are open is considered the most liquid time window; spreads are narrower during this period than

at other times of the day

 Market volatility Higher volatility leads to higher spreads to compensate market traders for the increased risk of holding those currencies

 Spreads in forward exchange rate quotes increase with maturity

因此， 1.6/2400NZD/IDR即0.00067NZD/IDR

方法2 (USD:NZD)/(USD:IDR)=IDR:NZD

=1.6/2400 IDR:NZD=0.00067

AUD: MXN = 6.4200 – 6.4481 Example2: USD: SFR =1.5960 – 70

USD: ASD =1.8225 – 35，求SFR:ASD 此时应当下式除以上式，交叉，

得：SFR: ASD=1.1412 – 1.1425

 Triangular arbitrage means converting from currency A to currency B, then

from currency B to currency C, then from currency C back to A If we end up with more of currency A at the end than we started with, we've earned an arbitrage profit

Triangular Arbitrage

Example

 Example: AUD: USD=0.6000 - 0.6015

USD: MXN=10.7000 - 10.7200 AUD: MXN=6.3000 - 6.3025 How to arbitrage from these markets?

0.6000-0.6015USD/AUD (1) 10.700-10.720MXN/USD (2) 6.3000-6.3025MXN/AUD (3)

Example: Triangular Arbitrage

 Mehmet is looking at two possible trades to deter mine their profit potential The first trade involves a possible triangular arbitrage trade using the Swiss, U.S and Brazilian currencies, to be executed based on

a dealer’s bid/offer rate quote of 0.5161/0.5163 in CHF/BRL and the interbank spot rate quotes presented in the following Exhibit

 Based on Exhibit, the most appropriate recommendation regarding the triangular arbitrage trade is to:

A decline the trade, no arbitrage profits are possible

B execute the trade, buy BRL in the interbank market and sell it to

Forward Discount And Premium

Forward discount or premium

 With the convention of giving the value of the quoted currency (the first

currency) in terms of units of the second currency, there is a premium on the quoted currency when the forward exchange rate is higher than the spot rate and a discount otherwise

Example: One month forward rate is EUR: USD=1.2468, the spot rate is

1.2500, it is a discount for EUR

 When a trader announces that a currency quotes at a premium, the

premium should be added to the spot exchange rate to obtain the value of the forward exchange rate

 The forward premium or discount

Mark-to-market value

 Mark-to-market value of a forward contract

 The value of the forward contract will changes as forward quotes for the currency pair change in the market

 The value of a forward contract (to the party buying the base currency)

at maturity (time T) is：

 The value of a forward currency contract prior to expiration is also known as the mark-to-market value

FP FP contract size V

days R

Example

 Yew Mun Yip has entered into a 90-day forward contract long CAD 1 million against AUD at a forward rate of 1.05358 AUD/CAD Thirty days after initiation, the following AUD/CAD quotes are available：

 The following information is available (at t=30) for AUD interest rates：

1 1 0.0116

T T

FP FP contract size V

days R

The International Parity Relationships

 Interest Rate Parity

 Covered Interest Rate Parity

 Uncovered Interest Rate Parity

 International Fisher Relation

 PPP

 Absolute PPP

 Relative PPP

 Ex-Ante Version of PPP

Covered Interest Rate Parity

 Covered Interest rate parity (IRP)

 The word 'covered’ in the context of covered interest parity means bound by arbitrage

 Covered interest rate parity holds when any forward premium or discount exactly offsets differences in interest rates, so that an investor would earn the same return investing in either currency

 Interest differential ≈forward differential

 Interest rate parity relationship:

 F (forward), S (spot) X/Y, rX and rY is the nominal risk-free rate in X and Y





11

X Y

r F

Covered Interest Rate Parity

 Covered interest arbitrage is a trading strategy that exploits currency

position when the interest rate parity equation is not satisfied

 When currencies are freely traded and forward contracts are available in the marketplace, interest rate parity must hold

 If it does not hold, arbitrage trading will take place until interest rate parity holds with respect to the forward exchange rate

 You can check for an arbitrage opportunity by using the covered interest differential, which says that the domestic interest rate should be the same as the hedged foreign interest rate

 The difference between the domestic interest rate and the hedged foreign

 1 rX   - 1 rY  F cov ered int erest differential

Summary for Covered Interest Rate Parity

 Assume a one year horizon The risk-free assets are typically bank deposits quoted using LIBOR for the currency involved The day count convention is Actual/360

Actual r

Example :

Example: Calculating the forward premium (discount)

 The following table shows the mid-market (average of the bid and offer) for the current CAD/AUD spot exchange rate as well as for AUD and

CAD 270-day LIBOR (annualized):

The forward premium (discount) for a 270-day forward contract for CAD/AUD would be closest to:

A - 0.0346

B - 0.0254

C +0.0261

270-day LIBOR (AUD) 4.87%

270-day LIBOR (CAD) 1.41%

Summary for arbitrage

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Covered Interest Rate Parity

 The U.S dollar interest rate is 8%, and the euro interest rate is 6% The spot exchange rate is $ 1.30 per euro, and the forward rate is $ 1.35 per euro

Determine whether a profitable arbitrage exists, and illustrate such an

Covered Interest Rate Parity

 Initially :

 Step1 : Borrow $ l,000 at 8% and purchased 1,000 / 1.30 = 769 23 euros

 Step2 : Invest the euros at 6%

 Step3：Sell the expected proceeds at the end of one year, 769.23 ( 1.06 )

= 815.38 euros, forward 1 year at $ 1.35 each

 After one year :

 Step1 : Sell the 815.38 euros under the terms of the forward contract at

$1.35 to get $1,100.76

 Step2 : Repay the $ 1,000 8 % loan, which is $ 1,080

 Step 3: Keep the difference of $ 20.76 as an arbitrage profit

Uncovered Interest Rate Parity

Uncovered interest rate parity

 If forward currency contracts are not available, or if capital flows are

restricted so as to prevent arbitrage, the relationship need not hold

 Uncovered interest rate parity refers to such a situation; uncovered in this context means not bound by arbitrage

 Uncovered interest rate parity suggests that nominal interest rates reflect expected changes in exchange rates

 The base currency is expected to appreciate (depreciate) by approximately

RX - RY when the difference is positive (negative) Uncovered interest rate parity assumes that investors are risk-neutral

 

0

1 1

t X

t Y

Uncovered Interest Rate Parity

 Comparing covered and uncovered interest parity

 Covered interest rate parity derives the no-arbitrage forward rate, while uncovered interest rate parity derives the expected future spot rate

 Covered interest parity is assumed by arbitrage

International Fisher Relation

International Fisher relation

 The international Fisher relation specifies that the interest rate differential between two countries should be equal to the expected inflation differential

 The condition assumes that real interest rates are stable over time and equal

across international boundaries

 The international Fisher relation is correct because differences in real interest rates between countries would encourage capital flows to take advantage of the differentials, ultimately equalizing real rates across countries

International Fisher Relation

International Fisher relation

p p

Absolute PPP

 Law of one price : identical goods should have the same price in all

locations

 Absolute PPP compares the price of a basket of similar goods between

countries, asks if the law of one price is correct on average

 In practice, even if the law of one price held for every good in two

economies, absolute PPP might not hold because the weights (consumption patterns) of the various goods in the two economies may not be the same

Relative PPP

 Relative PPP: change in the exchange rate depends on the inflation rates in

the two countries In its approximate form, the difference in inflation rates is equal to the expected depreciation (appreciation) of the currency The

country with the higher inflation should see its currency depreciate

 The formal equation for relative PPP is as follows: S (X/Y)

 Because there is no true arbitrage available to force the PPP relation to hold, violations of the relative PPP relation in the short run are common

 The evidence suggests that the relative form of PPP holds approximately in the long run

Ex-Ante Version of PPP

 Ex-Ante Version of PPP

 The ex-ante version of purchasing power parity is the same as relative

purchasing power parity except that it uses expected inflation instead of

actual inflation

 

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The International Parity Relationships Combined

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The International Parity Relationships Combined

The International Parity Relationships Combined

 Several observations can be made from the relationships among the various

parity relationships:

 Covered interest parity holds by arbitrage If forward rates are

unbiased predictors of future spot rates, uncovered interest rate parity also holds (and vice versa)

 Interest rate differentials should mirror inflation differentials This

holds true if the international Fisher relation holds If that is true, we can also use inflation differentials to forecast future exchange rates — which

is the premise of the ex-ante version of PPP

 By combining relative purchasing power parity with the international Fisher relation we get the uncovered interest rate parity

Forecast Future Spot Exchange Rates

 As stated earlier, uncovered interest rate parity and PPP are not bound by

arbitrage and seldom work over the short and medium terms Similarly, the forward rate is not an unbiased predictor of future spot rate However, PPP holds over reasonably long time horizons

 If relative PPP holds at any point in time, the real exchange rate would be constant called the equilibrium real exchange rate However, since relative PPP seldom holds over the short term, the real exchange rate fluctuates

around this mean-reverting equilibrium value

Long-Run Fair Value of An Exchange Rate

 Assess the long-run fair value of an exchange rate

 Macroeconomic balance approach Estimates how much current exchange rates must adjust to equalize a country’s expected current account imbalance and that country’s sustainable current account imbalance

 External sustainability approach Estimates how much current exchange rates must adjust to force a country’s external debt (asset) relative to GDP towards its sustainable level

 Reduced-form econometric model approach Estimates the equilibrium path of exchange rate movements based on patterns in several key

macroeconomic variables, such as trade balance, net foreign asset/liability, and relative productivity