Learning Module 1 Currency Exchange Rates: Understanding Equilibrium Value

Learning Module 1 Currency Exchange Rates: Understanding Equilibrium Value NOTATION CONVENTIONS Notation is generally not standardized in global foreign exchange markets, and there are several common ways of expressing the same currency pair (e.g., JPY/USD, USD:JPY, S/V). What is common in FX markets, however, is the concept of a "base" and a "price" currency when setting exchange rates. We will sometimes switch to discussing a "domestic" and a "foreign" currency, quoted as foreign/domestic (f/d). This is only an illustrative device for more easily explaining various theoretical concepts. The candidate should be aware that currency pairs are not described in terms of "foreign" and "domestic" currencies in professional FX markets. This is because what is the "foreign" and what is the "domestic" currency depend on where one is located, which can lead to confusion. For instance, what is "foreign" and what is "domestic" for a Middle Eastern investor trading CHF against GBP with the New York branch of a European bank, with the trade ultimately booked at the bank's headquarters in Paris? EXAMPLE 1 Bid-Offer Rates The following are spot rate quotes in the interbank market: USD EUR 11649/11651 JPY/USD 105.39/105.41 CAD/USD 1.3199/1.3201 SEK/USD 9.6300/96302 1. What is the bid-offer on the SEK/EUR cross rate implied by the interbank market? A. 0.1209/0.1211 8.2656/8.2668 C 11.2180/11.2201 Solution C is correct. Using the provided quotes and setting up the equations so that the cancellation of terms results in the SEK/EUR quote, SEK EUR SEK USD Hence, to calculate the SEK/EUR bid (offer) rate, we multiply the SEK/USD and USD/EUR bid (offer) rates to get the following Bid: 11.21809.6300 x 1.1649. Offer: 11.22019.63021.1651. 2. What is the bid-offer on the JPY/CAD cross rate implied by the interbank market? A. 78.13/78.17 79.8S/79.85 C 79.84/79.86 Solution C is correct. Using the intuitive equation-based approach, JPY JPY CAL JPY USD CAD USD USD USD CAD This equation shows that we have to invert the CAD/USD quotes to get the USD/CAD bid-offer rates of 0.75752/0.75763. That is, given the CAD/ USD quotes of 1.3199/1.3201, we take the inverse of each and interchange bid and offer, so that the USD/CAD quotes are (1/1.3201)/(1/1.3199), or 0.75752/0.75763. Multiplying the JPY/USD and USD/CAD bid-offer rates then leads to the following: 79.84-105.39 0.75752 Offer: 79.86 105.410.75763 3. If a dealer quoted a bid-offer rate of 79.81/79.83 in JPY/CAD, then a triangular arbitrage would involve buying: A. CAD in the interbank market and selling it to the dealer, for a profit of JPY 0.01 per CAD. B. JPY from the dealer and selling it in the interbank market, for a profit of CAD 0.01 per IFY. C CAD from the dealer and selling it in the interbank market, for a profit of JPY 0.01 per CAD. Solution C is correct. The implied interbank cross rate for JPY/CAD ix 79.84/79.86 (the answer to Question 2). Hence, the dealer is offering to sell the CAD (the base currency in the quote) too cheaply, at an offer rate that is below the interbank bid rate (79.83 versus 79.84, respectively). Triangular arbitrage would involve buying CAD from the dealer (paying the dealer's offer) and selling CAD in the interbank market (hitting the interbank bid), for a profit of JPY 0.01 (79.84-79.83) per CAD transacted. 4. If a dealer quoted a bid-offer of 79.82/79.87 in IPY/CAD, then you could A. not make any arbitrage profits. B. make arbitrage profits buying JPY from the dealer and selling it in the interbank market. C. make arbitrage profits buying CAD from the dealer and selling it in the interbank market Solution A is correct. The arbitrage relationship is not violated: The dealer's bid (offer) is not above (below) the interbank market's offer (bid). The implied interbank cross rate for JPY/CAD is 79.84/79.86 (the solution to Question 21 5. A market participant is considering the following transactions: Transaction 1 Buy CAD 100 million against the USD at 15:30 London time. Transaction 2 Sell CAD 100 million against the KRW at 21:30 London time. Sell CAD 10 million against the USD at 15:30 London time. Tramaction 3 Given the proposed transactions, what is the most likely ranking of the bid-offer spreads, from tightest to widest, under normal market conditions? A. Transactions 1. 2. 3 B. Transactions 2. 1, 3 Transactions 3, 1, 2 Solution C is correct. The CAD/USD currency pair is most liquid when New York and London are both in their most liquid trading periods at the same time (approximately 8:00 am. to 11:00 am. New York time, or about 13:00 to 16:00 London time). Transaction 3 is for a smaller amount than Transaction 1. Transaction 2 is for a less liquid currency pair (KRW/CAD is traded less than CAD/USD) and occurs outside of normal dealing hours in all three major centers (London, North America, and Asia); the transaction is also for a large amount EXAMPLE 2 Calculating the Forward Premium (Discount) The following table shows the mid-market rate (ie, the average of the bid and offer) for the current CAD/AUD spot exchange rate as well as for AUD and CAD 270-day MRR (annualized): Spot (CAD/AUD) 0.9000 270-day MRR (AUD) 1.47% 270-day MRR (CAD) 0.41% 1. The forward premium (discount) for a 270-day forward contract for CAD/ AUD would be closest to: A. -0.0094. B. -0.0071. C. +0.0071 Solution B is correct. The equation to calculate the forward premium (discount) is as follows: Actual Astust Fra-Sra-Spa Because AUD is the base currency in the CAD/AUD quote, putting in the information from the table gives us 0.9000 1-0.0147 (0.0041-0.0147) -0.0071. EXAMPLE 3 Forward Rates and the Mark-to-Market Value of Forward Positions A dealer is contemplating trade opportunities in the CHF/GBP currency pair. The following are the current spot rates and forward points being quoted for the CHF/GBP currency pair. Spot rate (CHF/GBP) 1.2939/1.2941 One month -8.3/-7.9 Two months -17.4/-16.8 -25.4/-34.6 Three months -35.4/-34.2 Four months -45.9/44.1 Five months Six months -56.5/-54.0 1. The current all-in bid rate for delivery of GBP against the CHF in three months is closest to: A. 1.29136. B. 1.29150. C. 1.29164 Solution A is correct. The current all-in three-month bid rate for GBP (the base currency) is equal to 1.2939 + (-25.4/10,000) - 1.291.36. 2. The all-in rate that the dealer will be quoted today by another dealer to sell the CHF six months forward against the GBP is closest to: A. 1.28825. B. 1.28835. C. 1.28870. Solution C is correct. The dealer will sell CHF against the GBP, which is equivalent to buying GBP (the base currency) against the CHF. Hence, the offer side of the market will be used for forward points. The all-in forward price will be 1.2941+(-540/10,000) 1.28870. 3. Some time ago, Laurier Bay Capital, an investment fund based in Los Angeles, hedged a long exposure to the New Zealand dollar by selling NZD 10 million forward against the USD, the all-in forward price was 0.7900 (USD/ NZD). Three months prior to the settlement date, Laurier Bay wants to mark this forward position to market. The bid offer for the USD/NZD spot rate, the three-month forward points, and the three-month MRRs (annualized) are as follows: Spot rate (USD/NZD) 0.7825/0.7830 Three-month points -12.1/-10.0 Three-month MRR (NZD) 3.31% Three-month MRR (USD) 0.31% The mark-to-market value for Laurier Bay's forward position is closest to: A. USD 87,100. B. USD 77,437. C. USD 79,938 Solution C is correct. Laurier Bay sold NZD 10 million forward to the settlement date at an all-in forward rate of 0.7900 (USD/NZD). To mark this position to market, the fund would need an offsetting forward transaction involving buying NZD 10 million three months forward to the settlement date. The NZD amounts on the settlement date net to zero. For the offsetting forward contract, because the NZD is the base currency in the USD/NZD quote, buying NZD forward means paying the offer for both the spot rate and the forward points. This scenario leads to an all-in three-month forward rate of 0.7830-0.0010 0.7820. On the settlement day, Laurier Bay will receive USD 7,900,000 (NZD 10,000,000 × 0.7900 USD/NZD) from the original for- ward contract and pay out USD 7,820,000 (NZD 10,000,000 0.7820 USD/ NZD) based on the offsetting forward contract. The result is a net cash flow on the settlement day of 10,000,000 (0.7900-0.7820) USD 80.000. This is a cash inflow because Laurier Bay sold the NZD forward and the NZD depreciated against the USD. This USD cash inflow will occur in three months. To calculate the mark-to-market value of the original forward po- sition, we need to calculate the present value of this USD cash inflow using the three-month USD discount rate (we use USD MRR for this purpose): USD 80,000 1+0.0031() +USD 79,938. Now, suppose that instead of having a long exposure to the NZD, Laurier Bay Capital had a long forward exposure to the USD, which it hedged by selling USD 10 million forward against the NZD at an all-in forward rate of 0.7900 (USD/NZD). Three months prior to settlement date, it wants to close out this short USD forward position. Using the above table, the mark-to-market value for Laurier Bay's short USD forward position is closest to A -NZD 141,117. B. NZD 139,959. C-NZD 87,100. Solution B is correct. Laurier Bay initially sold USD 10 million forward, and it will have to buy USD 10 million forward to the same settlement date (ie., in three months time) in order to close out the initial position. Baying USD using the USD/NZD currency pair is the same as selling the NZD. Because the NZD is the base currency in the USD/NZD quote, selling the NZD means calculating the bid rate: 0.7825+(-12.1/10,000)-0.78129. At settlement, the USD amounts will net to zero (USD 10 million both bought and sold). The NZD amounts will not net to zero, however, because the all-in forward rate changed between the time Laurier Bay initiated the original position and the time it closed out this position. At initiation, Lau rier Bay contracted to sell USD 10 million and receive NZD 12.658,238 (Le, 10,000,000/0.7900) on the settlement date. To close out the original forward contract, Laurier Bay entered into an offsetting forward contract to receive USD 10 million and pay out NZD 12,799,345 (ie, 10,000,000/0.78129) at settlement. The difference between the NZD amounts that Laurier Bay will receive and pay out on the settlement date equals NZD 12,658,228 NZD 12,799,345 NZD 141,117. This is a cash outflow for Laurier Bay because the fund was short the USD in the original forward position and the USD subsequently appreciated (ie, the NZD subsequently depreciated because the all-in forward rate in USD/NZD dropped from 0.7900 to 0.78129). This NZD cash outflow occurs in three months' time, and we must calculate its present value using the three-month NZD MRR -NZD 141,117 1+0.0331 NZD 139,959. 340. EXAMPLE 5 PPP and the International Fisher Effect An Australia-based fixed-income investment manager is deciding how to allocate her portfolio between Australia and Japan, (As before, the AUD is the domestic currency) Australia's cone-year deposit rate is 3%, considerably higher than Japan's 1% rate, but the Australian dollar is estimated to be roughly 10% overvalued relative to the Japanese yen based on purchasing power parity. Before making an asset allocation, the investment manager considers the implications of interest rate differentials and PPP imbalances. 1. All else equal, which of the following events would restore the Australian dollar to its PPP value? A. The Japanese inflation rate increases by 2%. The Australian inflation rate decreases by 10% The JPY/ALUD exchange rate declines by 10% Solution C is correct. If the Australian dollar is overvalued by 10% on a PPP basis, with all else held equal, a depreciation of the JPY/AUD rate by 10% would move the Australian dollar back to equilibrium. 2. If real interest rates in Japan and Australia were equal, then under the international Fisher effect, the inflation rate differential between Japan and Australia would be closest to A. 0 2% C10% Solution B is correct. If the real interest rates were equal, then the difference in nominal yields would be explained by the difference in inflation rates (%15). 3. According to the theory and empirical evidence of purchasing power parity, which of the following would not be true if PPP holds in the long run? A. An exchange rate's equilibrium path should be determined by the long-term trend in domestic price levels relative to foreign price levels. 1. Deviations from PPP might occur over short- and medium-term periods ods, but fundamental forces should eventually work to push exchange rates toward their long-term PPP path High-inflation countries should tend to see their currencies appreciate over time. Solution Cis correct. According to PPP, high-inflation countries should see their currencies depreciate (at least, over the longer term) in order to re-equilibrate real purchasing power between countries. 4. Which of the following would best explain the failure of the absolute version of PPP to hold A. Inflation rates vary across countries B. Real interest rates are converging across countries. C Trade barriers exist, and different product mises are consumed across countries. Solution Cis correct. The absolute version of PPP assumes that all goods and services ace tradable and that the domestic and foreign price indexes include the same bundle of goods and services with the same exact weights in each country EXAMPLE 6 The Relationships among the International Parity Conditions 1. Which of the following is a no-arbitrage condition? A. Real interest rate parity 8. Covered interest rate parity C. Uncovered interest rate parity Solution 8 is correct. Covered interest rate parity is enforced by equating the investment return on two riskless investments (domestic and currency-hedged foreign). 2. Forward rates are unbiased predictors of future spot rates if two parity conditions hold. Which of the following is not one of these conditions? A. Real interest rate parity 8. Covered interest rate parity C. Uncovered interest rate parity Solution A is correct. Both covered and uncovered interest rate parity must hold for the forward rate to be an unbiased predictor of the future spot rate. Real interest rate parity is not required. 3. The international Fisher effect requires all but which of the following to hoid A. Ex ante PPP B. Absolute PPP C. Real interest rate parity Solution B is correct. The international Fisher effect is based on real interest rate parity and ex-ante PPP (not absolute PPP). 4. The forward premium/discount is determined by nominal interest rate differentials because of A. the Fisher effect. 8. covered interest parity. C real interest rate parity. Solution B in correct. The forward premium/discount is determined by covered interest rate arbitrage. 5. If all of the key international parity conditions held at all times, then the expected percentage change in the spot exchange rate would equal all except which of the following? A. The real yield spread B. The nominal yield spread The expected inflation spread Solution A is correct. If all the international parity conditions held, the real yield spread would equal zero, regardless of expected changes in the spot ex-change rate. EXAMPLE 7 Carry Trade Strategies A currency fund manager is considering allocating a portion of her EX portfolio to carry trade strategies. The fund's investment committee asks the manager a number of questions about why she has chosen to become involved in FX carry trades and how she will manage the risk of potentially large downside moves associated with the unwinding of carry trades. Which of the following would be her best responses to the investment committee's questions? 1. Carry trades can be profitable when A. covered interest rate parity does not hold. B. uncovered interest rate parity does not hold, The international Fisher effect does not hold. Solution B is correct. The carry trade is based on the supposition that uncovered interest rate parity does not hold. 2. Over time, the return distribution of the fund's FX carry trades is most likely to resemble a: A normal distribution with fat tails. B. distribution with fat tails and a negative skew. C. distribution with thin tails and a positive skaw. Solution 8 is correct. The "crash risk" of carry trades implies a fat-tailed distribution skewed toward a higher probability of large losses (compared with a normal distribution). 3. The volatility of the fund's returns relative to its equity base is best explained by: A leverage. B. low deposit rates in the funding currency. C. the yield spread between the high and low-yielding currencies. Solution A is correct. Carry trades are leveraged trades (borrow in the funding currency, anvest in the high-yield currency), and leverage increases the volatility in the investor's return on equity. A. +0.03% B. +1.53% C. +1.63% Solution B is correct. To calculate the all-in return for a Japanese investor in a one-year AUD MRR deposit, we must first calculate the current and one-year later JPY/AUD cross rates. Because USD 10000 buys JPY 105.40 today and AUD 10000 buys USD 0.6810 today, today's IPY/AUD cross rate is the product of these two numbers: 105.40 x 0.6810-71.78 (rounded to two decimal places). Similarly, one year later, the observed cross rate is 104.60 0.685071.66 (rounded to two decimal places). Accordingly, measured in yen, the investment return for the unhedged Australian MRR deposit is (1/71.78)(11.70%)71.65-1-0.0152 Against this 1.52% gross return, however, the manager must charge the borrowing costs to fund the carry trade investment (one-year JPY MRR was 0.10%) Hence, the net return on the carry trade is 1.52%-0.10%-1.42% We can also calculate the profit using a transactional approach. Assuming an initial position of, for example, 100 yen (JPY 100), the investor will obtain JPY 1001/JPY 7178 AUD 13931. After one year, the investment will be worth AUD 1.3931x1017 AUD 1.4168. Converting back to yen in one year results in AUD 1.4168 JPY 71.65/AUDIPY 101.51. Paying off the yen loan results in a profit of JPY 101.51 (JPY 100x1001) JPY 141 This is equivalent to the 1.42% profit calculated previously (slight difference arising due to rounding). PERSISTENT CURRENT ACCOUNT DEFICITS: THE US CURRENT ACCOUNT AND THE US DOLLAR The historical record indicates that the trend in the US current account has been an important determinant of the long-term swings in the US dollar's value but also that there can be rather long lags between the onset of a deterioration in the current account balance and an eventual decline in the dollar's value. For example, the US current account balance deteriorated sharply in the first half of the 1980s, yet the dollar soared over that period. The reason for the dollar's strength over that period was that high US real interest rates attracted large inflows of capital from abroad, which pushed the dollar higher despite the large US external imbalance. Eventually, however, concerns regarding the sustainability of the ever-widening US current account deficit triggered a major dollar decline in the second half of the 1980s. History repeated itself in the second half of the 1990s, with the US current account balance once again deteriorating while the dollar soared over the same period. This time, the dollar's strength was driven by strong foreign direct investment, as well as both debt- and equity-related flows into the United States. Beginning in 2001, however, the ever-widening US current account deficit, coupled with a decline in US interest rates, made it more difficult for the United States to attract the foreign private capital needed to finance its current account deficit. The dollar eventually succumbed to the weight of ever-larger trade and current account deficits and began a multi-year slide, starting in 2002-2003. Interestingly, the US dollar has undergone three major downward cycles since the advent of floating exchange rates: 1977-1978, 1985-1987, and 2002-2008. In each of those downward cycles, the dollar's slide was driven in large part by concerns over outsized US current account deficits coupled with relatively low nominal and/or real short-term US interest rates, which made it difficult to attract sufficient foreign capital to the United States to finance those deficits. EXCHANGE RATE ADJUSTMENT IN SURPLUS NATIONS: JAPAN AND CHINA Japan and, for a number of years, China represent examples of countries with large current account surpluses and illustrate the pressure that those surpluses can bring to bear on currencies. In the case of Japan, its rising current account surplus has exerted persistent upward pressure on the ven's value versus the dollar over time. Part of this upward pressure simply reflected the increase in demand for yen to pay for Japan's merchandise exports. But some of the upward pressure on the yen might also have stemmed from rising commercial tensions between the United States and Japan. Protectionist sentiment in the United States rose steadily with the rising bilateral trade deficit that the United States ran with Japan in the postwar period. US policymakers contended that the yen was undervalued and needed to be appreciated. With the increasing trade imbalance between the two countries contributing to more heated protectionist rhetoric, Japan felt compelled to tolerate steady upward pressure on the yen. As a result, the yen's value versus the dollar has tended to move in sync with the trend in Japan's current account surplus. EXAMPLE 8 Capital Flows and Exchange Rates Monique Kwan, a currency strategist at a major foreign exchange dealer, is responsible for formulating trading strategies for the currencies of both developed market (DM) and emerging market (EM) countries. She examines two countries DM and one EM-and notes that the DM country has what is considered a low-yield safe haven currency while the EM country has a high-yield currency whose value is more exposed to fluctuations in the global economic growth rate. Kwan is trying to form an opinion about movements in the exchange rate for the EM currency. 1. All else equal, the exchange rate for the EM currency will most likely depreciate if the A. long-run equilibrium value of the high-yield currency is revised upward. B. nominal yield spread between the EM and DM countries increases over time. Expected inflation differential between the EM and DM countries is revised upward. Solution C is correct. All else equal, an increase in the expected inflation differential should lead to the depreciation of the EM currency. 2. An increase in safe-haven demand would most likely A. increase the risk premium demanded by international investors to hold assets denominated in the EM currency. B. raise the return earned on carry trade strategies. C. exert upward pressure on the value of the EM currency. Solution A is correct. During times of intense risk aversion, investors will crowd into the safe haven currency. This tendency implies an increased risk premium dermanded by investors to hold the EM currency. 3. Kwan notes that the DM country is running a persistent current account deficit with the EM country. To isolate the influence of this chronic im- balance on exchange rates, she focuses only on the bilateral relationship between the EM and DM countries and makes the simplifying assumption that the external accounts of these two countries are otherwise balanced (ie, there are no other current account deficits). Over time and all else equal, the persistent current account deficit with the EM country would most likely lead to: A. a large buildup of the EM country's assets held by the DM country. B. an increase in the trade competitiveness of the EM country. C is correct. Over time, the DM country will see its level of external debt rise as a result of the chronic current account imbalance. Eventually, this trend should lead to a downward revision of the DM currency's long-run equilibrium level (via the debt sustainability channel). This is equivalent to an increase in the EM currency's long-run exchange rate. A is incorrect because the DM country's current account deficit is likely to lead to a build-up in DM country assets held by the EM country. B is incorrect because. at some point, the currency strength should contribute to deterioration in the trade competitiveness of the country with the trade surplus (the EM country). 4. Kwan notes that because of the high yield on the EM country's bonds, international investors have recently been reallocating their portfolios more heavily toward this country's assets. As a result of these capital inflows, the EM countries have been experiencing boom-like conditions. Given the current boom-like conditions in the EM economy, in the near term, these capital inflows are most likely to lead to: A. a decrease in inflation expectations in the EM. B. an increase in the risk premium for the EM. Can increase in the EM currency value. Solution C is correct. Given the current investor enthusiasm for the EM country's assets and the boom-like conditions in the country, it is most likely that in the near term, the EM currency will appreciate. At the same time, expected inflation in the EM country is also likely increasing and given the enthusiasm for EM the risk premium is likely decreasing. 5. If these capital inflows led to an unwanted appreciation in the real value of its currency, the EM country's government would most likely. A. impose capital controls. B. decrease taxes on consumption and investment. Cbuy its currency in the foreign exchange market. Solution A is correct. To reduce unwanted appreciation of its currency, the EM country would be most likely to impose capital controls to counteract the surging capital inflows. Because these inflows are often associated with overinvestment and consumption, the EM government would not be likely to encourage these activities through lower taxes. Nor would the EM country be likely to encourage further currency appreciation by intervening in the market to buy its own currency. 6. If government actions were ineffective and the EM country's bubble eventually burst, this would most likely be reflected in an increase in: A. the risk premium for the EM. B. the EM currency value. C. the long-run equilibrium EM currency value. Solution A is correct. Episodes of surging capital flows into EM countries have often ended badly (with a rapid reversal of these inflows as the bubble bursts). This is most likely to be reflected in an increase in the EM risk premium. It is much less likely that a bursting bubble would be reflected in an increase in either the EM currency value or its long-term equilibrium value. 7. Finally, Kwan turns to examine the link between the value of the DM country's currency and movements in the DM country's main stock market index. One of her research associates tells her that, in general, the correlation between equity market returns and changes in exchange rates has been found to be highly positive over time. The statement made by the research associate is: A. correct B. incorrect, because the correlation is highly negative over time. C. incorrect, because the correlation is not stable and tends to converge toward zero in the long run. Solution C is correct. Correlations between equity returns and exchange rates are unstable in the short term and tend toward zero in the long run Monetary Policy and Exchange Rates: The Historical Evidence Historically, changes in monetary policy have had a profound impact on exchange rates. In the case of the US dollar, the Federal Reserve's policy of quantitative easing after the global financial crisis resulted in dollar depreciation from mid-2009 to 2011. The subsequent ending of quantitative easing in 2014, along with the anticipation that the United States would raise interest rates before many other countries, played a key role in driving the dollar higher. Beginning in 2013, Abenomics-fiscal stimulus, monetary easing, and structural reforms- and the use of quantitative easing in Japan led to a steady decline in interest rates and eventually to negative interest rates in 2016. From 2013 to 2015, the value of the yen changed from roughly JPY 90/USD to JPY 120/USD. Likewise, the use of quantitative easing by the European Central Bank in 2015 led to declines in the value of the euro. Excessively expansionary monetary policies by central banks in emerging markets have often planted the seeds of speculative attacks on their currencies. In the early 1980s, exchange rate crises in Argentina, Brazil, Chile, and Mexico were all preceded by sharp accelerations in domestic credit expansions. In 2012, Venezuela began a period of triple-digit inflation, followed by a massive currency depreciation and an economic crisis. EXAMPLE 9 Monetary Policy and Exchange Rates Monique Kwan, the currency strategist at a major foreign exchange dealer, is preparing a report on the outlook for several currencies that she follows. She begins by considering the outlook for the currency of a developed market country with high capital mobility across its borders and a flexible exchange rate. This DM country also has low levels of public and private debt. Given these conditions, Kwan tries to assess the impact of each of the following policy changes. 1. For the DM currency, increasing the degree of monetary easing (reducing interest rates and increasing money supply) will most likely A. cause the currency to appreciate. B. cause the currency to depreciate C. have an indeterminate effect on the currency. Solution B is correct. A decrease in the policy rate would most likely cause capital to re-allocate to higher-yielding markets. This would lead to currency depreciation. 2. The pursuit of an expansionary domestic fiscal policy by the DM country will, in the short run, most likely. A. cause the domestic currency's value to appreciate. 8. cause the domestic currency's value to depreciate. C. have an indeterminate effect on the domestic currency's value Solution A is correct. An expansionary fiscal policy will lead to higher levels of government debt and interest rates, which will attract international capital flows. (In the long run, however, an excessive buildup in debt may eventually cause downward pressure on the domestic currency.) 3. Next, Kwan turns her attention to an emerging market country that has low levels of public and private debt. Currently, the EM country has a fixed exchange rate but no controls over international capital mobility. However, the country is considering replacing its fixed exchange rate policy with a policy based on capital controls. These proposed controls are meant to reduce international capital mobility by limiting short-term investment flows ("hot money) in and out of its domestic capital markets. To maintain the exchange rate peg while increasing the degree of monetary easing, the EM country will most likely have to: A. tighten fiscal policy. B. decrease interest rates. C. buy its own currency in the FX market. Solution C is correct. The looser monetary policy will lead to exchange rate depreciation. To counter this effect and maintain the currency peg, the central bank will have to intervene in the FX market, buying the country's own currency. A is incorrect because tighter fiscal policy is associated with lower interest rates and is therefore likely to increase rather than mitigate the downward pressure on the domestic currency. Similarly, B is incorrect because a move to lower interest rates would exacerbate the downward pressure on the currency and, hence the pressure on the peg. 4. After the EM country replaces its currency peg with capital controls, would its exchange rate be unaffected by a tightening in monetary policy? A. Yes B. No. The domestic currency would appreciate. C. No, the domestic currency would depreciate. Solution B is correct. In general, capital controls will not completely eliminate capital flows but will limit their magnitude and responsiveness to investment incentives such as interest rate differentials. At a minimum, flows directly related to financing international trade will typically be allowed. The exchange rate will still respond to monetary policy. With limited capital mobility, however, monetary policy's main influence is likely to come through the impact on aggregate demand and the trade balance. A tighter domestic monetary policy will most likely lead to higher interest rates and less domestic demand, including less demand for imported goods. With fewer imports and with ex-ports held constant, there will be modest upward pressure on the currency. 5. After the EM country replaces its currency peg with capital controls, the simultaneous pursuit of a tight monetary policy and a highly expansionary fiscal policy by the EM country will most likely. A. cause the currency to appreciate. B. cause the currency to depreciate. C have an indeterminate effect on the currency. Solution C is correct because (1) capital mobility is low, so the induced increase in interest rates is likely to exert only weak upward pressure on the currency: (2) the combined impact on aggregate demand is indeterminate, and (3) f aggregate demand increases, the downward pressure on the currency due to a worsening trade balance may or may not fully offset the upward pressure exerted by capital flows. EXAMPLE 10 Fiscal Policy and Exchange Rates Monique Kwan is continuing her analysis of the foreign exchange rate outlook for selected countries. She examines a DM country that has a high degree of capital mobility and a floating-rate currency regime. Kwan notices that although the current outstanding volume of government debt is low, as a percentage of GDP, it is rising sharply as a result of expansionary fiscal policy. Mareone projections int the government debt-to-GDF ratie point to further increases well into the future. Kwan was the Mundell-Fleming and portfolio balance models to form an episode about both the short-run and long-ran implications for the DM country's exchange rate. 1. Over the short run, Kwan is most likely to expect appreciation of the DM's currency. An increase in the DM's asset prices. Ca decrease in the DAC's risk premier Solution A is correct. The DM country currently has a low debt mod (as a percentage of GDP), and in the short run, its expansionary fiscal policy will lead to higher interest rates and higher real rates relative to other countries. This path should lead to currency appreciation. The higher domestic interest rates will be equal) depress local asset prices iso B is incorrect), and the rating debt load is likely to increase rather than decrease the risk premium (se C is incorrect) 2. Over the medium term, as the DM country's government debt becomes harder to finance, Ksean would be most likely to expect that A fiscal policy will turn more accommodative. B. the mark to market value of the debt will increase C. monetary policy will become more accommodative. Solution C is correct. As government debt becomes harder to finance, the government will be tempted to monetize the debt through an accommodative monetary policy. A is incorrect because an inability to finance the debt will make it hard for fiscal policy to become more accommodative. B is incorrect because as investors demand a higher risk lugher return for hedding the DM country's debt, the mark-to-market value of the debt will decline, buy prices will decrease and bond yields will increase). 3. Assuming that the DMM country's government debt becomes harder to finance and there is no change in monetary policy, Kwan is most likely to expect that ever the longer term, there will be a fiscal policy response that will lead to A. currency appreciation as yields ribe 8. currency depreciation as yields decline C. an indeterminate impact on the currency, depending on which effect prevails Solution Bis correct. As the DM country's debt ratto deteriorates, foreign investors will demand a higher rate of return to compensate them for the increased risk. Assuming that the central bank will not accommodate (monetize) the rising government debt, the most likely fiscal response is an eventual move toward fiscal consolidation-reducing the public deficit and debt levels that were causing the debt metrics to deteriorate. This policy adjustment would assume fewer government bonds. All else equal, bond yields would decrease, leading to a weaker domestic currency over the longer ters A is incorrect because currency appreciation is not likely to accompany tising, yields when the government is having difficulty financing its deficit There would be a rising risk permission la deteriorating investor appetite for holding DM amets, and hence a currency appreciation would be unlikely despite high DSM yields. To avoid paying these high yields on its debt, the DM government would eventually have to take measures to seduce its deńce spending This approach would eventually help reduce investor risk aversion and DM yields. Cis incorrect because given the deterioration in the DM's dent metrics, a depreciation of its exchange rate is likely to be an important part of the restoration of financial market equilibrium. ICELAND'S CURRENCY CRISIS OF 2008 Iceland, a country with a population of 320,000, had traditionally relied on the fishing. energy, and aluminum industries for economic growth. That began to change in 2001. when the banking industry was liberalized. Three banks dominated the Icelandic bank- ing industry: Glitnir, Kaupthing, and Landsbanki. Given Iceland's small population, these banks sought growth by offering short-term, internet-based deposit accounts to foreign investors. These accounts offered attractive interest rates and were denominated in foreign currencies. In particular, many of the depositors were British, Dutch, and other European citizens who held deposit accounts denominated in pounds and euros. With government guarantees on their deposit accounts, the banking industry grew rapidly. The largest bank, Kaupthing, experienced asset growth of 30 times between 2000 and 2008. The three banks increased lending rapidly, with many of their loans being long term, resulting in a maturity mismatch of assets and liabilities. The banks' assets were more than 14 times the country's GDP, while foreign debt was five times GDP. The three banks constituted more than 70% of the national stock market capitalization. The economy expanded at a real growth rate above 20% annually between 2002 and 2005, and many Icelanders left traditional industries to work in the banks. Iceland earned the nickname "Nordic Tiger" as per capita GDP approached USD 70,000 in 2007. The Icelandic krona increased in value against the US dollar by 40% between 2001 and 2007. By 2007, the unemployment rate was less than 1%. Icelanders went on a shopping spree for consumer goods, in part by using loans tied to the value of foreign currencies, motivated by lower interest rates abroad. A 2002 trade surplus turned into a trade deficit in the years 2003-2007. Iceland's external debt in 2008 was more than 7 times its GDP and 14 times its export revenue. Broad-based monetary aggregates grew at a rate of 14%-35% annually from 2002 to 2007. By the fall of 2008, inflation had reached 14%. As the global financial crisis unfolded in 2008, interbank lending declined and Icelandic banks were unable to roll over their short-term debt. Anxious foreign depositors began withdrawing their funds. In the first half of 2008, the krona depreciated by more than 40% against the euro. As the Icelandic currency declined in value, it became more difficult for the banks to meet depositors' liquidity demands, while at the same time the banks' depreciating krona-denominated assets could not be used for collateral financing. The three banks collapsed in 2008. Unfortunately for foreign depositors, because of the relative size of the banks, the government guaranteed only domestic deposits. Iceland's central bank became technically insolvent, as its EUR 2 billion in assets was dwarfed by Iceland's debt to foreign banks of EUR 50 billion. Trading in the stock market was suspended in October 2008. When it reopened several days later, the Icelandic Stock Market Index fell by more than 77% as a result of the elimination of the three banks' equity value. The government attempted to peg the krona to the euro in October 2008 but abandoned the peg one day later. When trading in the currency was resumed later that month, the currency value fell by more than 60% and trading was eventually suspended. Iceland increased interest rates to 18% to stem outflows of Krona and imposed capital controls on the selling of Krona for foreign currency. The Icelandic economy contracted, and per capita GDP fell 9.2% in 2009. By the spring of 2009, unemployment was 9%. The country subsequently required a bailout from the IMF and its neighbors of USD 4.6 billion. Source: Federal Reserve Bank of St. Louis database: Bekaert and Hodrick 2018; Matsangou 2015; Daniels and VanHoose 2017.