Currency Exchange Rates: Determination and Forecasting

02 Economics Economics 2024 Level II High Yield Notes LM01 Currency Exchange Rates: Determination and Forecasting Bid – offer spread Currency quotes in the foreign exchange market are two sided; they have both a bid price and an offer price. The bid price represents the price at which the dealer is willing to buy the currency and the offer price represents the price at which the dealer is willing to sell the currency. The size of the bid-offer spread that the dealer offers to clients can vary depending on the following factors. Primary Factors 1. The currency pair involved: Liquidity in major currency pairs is generally higher than that in less popular pairs. 2. The time of the day: The interbank market is most liquid when major trading centers are open. 3. Market volatility: If market volatility is high, bid-offer spreads will be high. Secondary Factors 1. The size of the transaction: The larger the transaction size, the wider the bid-offer spread. 2. The relationship between the dealer and the client: In order to secure regular business from the client in foreign exchange as well as in other asset classes, the dealer may offer tight bid-offer spreads. 3. Client’s credit profile: If the client has a poor credit history, the dealer may offer a wider bid-offer spread. Triangular arbitrage A triangular arbitrage opportunity exists if either of these conditions is violated: • Dealer cross-rate bid must be lower than the implied interbank cross-rate offer • Dealer cross-rate offers must be higher than the implied interbank cross-rate bid To determine whether a triangular arbitrage opportunity exists, follow these steps: 1. Calculate the cross-rate implied by the interbank market. 2. Compare the interbank rate with the dealer rate. • If dealer bid > interbank offer (DBi G IO) → buy base currency in the interbank market and sell to the dealer • If dealer offer < interbank bid (DO L IB) → buy base currency from dealer and sell in the interbank market 3. If you are asked to calculate the arbitrage profit, the additional steps will depend on what currency you start with and the currency in which you need to report the profit. © IFT. All rights reserved 1 Economics 2024 Level II High Yield Notes Example: Consider an interbank quote of 85.76/85.80 on the currency pair A/B. The dealer quotes on the same currency from three dealers are as follows: Dealer 1 quote: 85.74/85.81 Dealer 2 quote: 85.73/85.75 Dealer 3 quote: 85.81/85.83 When assessing for triangular arbitrage, we suggest using a ‘number line’ format, where the interbank and dealer rates are represented along a number line: Write the interbank rate within two lines as follows: 85.76 85.80 Write all dealer quotes with reference to the interbank quote within the two lines. So, a number less than 85.76 would appear to the left of the interbank quote whereas a number greater than 85.80 would appear to the right of the interbank quote. The three dealer quotes can be represented as follows: Interbank quote 85.76 85.80 Dealer 1 quote 85.74 85.81 Dealer 2 quote 85.73 85.75 Dealer 3 quote 85.81 85.83 Arbitrage condition DO L IB DBi G IO If the dealer quote falls entirely to the left of the interbank quote, then the DO L IB condition exists, and an arbitrage profit can be made by buying the base currency from the dealer and selling it in the interbank market. On the other hand, if the dealer quote falls entirely to the right of the interbank quote, then the DBi G IO condition exists and an arbitrage profit can be made by buying the base currency in the interbank market and selling it to the dealer. Any other arrangement of the dealer quote will not result in an arbitrage opportunity. Therefore, in our example, dealer 1's quote doesn’t provide an arbitrage opportunity. Dealer 2's quote provides an arbitrage opportunity as the DO L IB condition is met, and dealer 3's quote provides an arbitrage opportunity as the DBi G IO condition is met. Spot rates and forward rates The spot rate is the rate at which the currency trades in the market today. The forward rate is an agreed-upon rate to buy or sell a currency at a future date. The forward rate is calculated as: Actual Actual Fp/b = Sp/b (1 + ip [ ]) / (1 + ib [ ]) 360 360 This expression implies that: © IFT. All rights reserved 2 Economics • • 2024 Level II High Yield Notes If the base currency interest rate is less than the price currency interest rate then forward rate > spot rate and the forward premium is positive. If the base currency interest rate is greater than the price currency interest rate then forward rate < spot rate and the forward premium is negative. In professional FX markets, forward rates are quoted in terms of points, which represent the difference between the forward rate and the spot rate. Mark-to-market value of a forward contract Mark-to-market value of forward contracts is the profit (or loss) that would be realized from closing out the position at current market prices. A forward contract is marked to market through the following steps: 1. Create an offsetting forward position that is equal to the original forward position. 2. Determine the appropriate all-in forward rate for this new, offsetting forward position. 3. Calculate the cash flow on the settlement day. 4. Calculate the present value of this cash flow at the future settlement date. Example: Suppose that an individual buys 10 million GBP against AUD in a six-month forward contract with a forward rate of 1.6100 AUD/GBP. What is the value three months later if the spot rate = 1.6210/1.6215 and three-month points = 130/140? The three month AUD Libor = 4.8%. 1. The individual would sell 10 million GBP against AUD in a 3-month forward contract. The term of the contract is three months because three months have already passed and the remaining time to the maturity of the original contract is three months. 2. As the individual has to sell the currency, the appropriate rate is the market bid rate, i.e. 1.6210 +130/10,000 = 1.6340. 3. For our individual, the buying rate is 1.6100 and the selling rate is 1.6340. This means the individual sells higher than he bought, resulting in a cash inflow of (1.6340 – 1.6100) × 10,000,000 = +AUD 240,000. 4. As the cash flow is to occur at the contract maturity date (3 months in our example), the cash flow must be discounted to find its current value. The cash flow is in AUD, therefore, the relevant discount rate is the 3-month AUD LIBOR. The present value of the cash flow is, therefore: AUD 240,000 = AUD 237,154 90 1 + 0.048 (360) © IFT. All rights reserved 3 Economics 2024 Level II High Yield Notes International parity conditions Covered interest rate parity states that an investment in a foreign money market instrument that is completely hedged against exchange rate risk should yield exactly the same return as an otherwise identical domestic money market investment. Actual Actual Fp/b = Sp/b (1 + ip [ ]) / (1 + ib [ ]) 360 360 Uncovered interest rate parity states that the expected return on an un-hedged foreign currency position should equal the return on a similar domestic currency investment. 𝑒 %∆𝑆𝑝/𝑏 = 𝑖𝑝 − 𝑖𝑏 Forward rate parity states that the forward exchange rate will be an unbiased predictor of the future spot exchange rate if covered interest rate parity and uncovered interest rate parity hold. Actual Actual Expected Spot rate = Fp/b = Sp/b (1 + ip [ ]) / (1 + ib [ ]) 360 360 The ex-ante version of PPP states that ‘expected’ changes in spot exchange rates are driven by ‘expected’ inflation differentials: e %∆Sp/b = πep − πeb The international Fisher effect states that if uncovered interest rate parity and ex ante PPP hold, the foreign-domestic nominal yield spread is determined solely by the foreigndomestic expected inflation differential. ip − ib = πep − πeb If all the key international parity conditions held at all times, then the expected percentage change in the spot exchange rate would equal • the forward premium or discount (expressed in %) • the nominal yield spread between countries • the difference between expected national inflation rates Covered interest rate parity and carry trade An FX carry trade involves taking long positions in a high yielding currency and a short position in a low yielding currency. If the uncovered interest rate parity holds, then exchange rate movements would cancel out the extra return that a high yielding foreign currency would earn such that the net return would be equal to that of the lower yielding domestic currency. However, empirical evidence suggests that: high-yield currencies, on average, have not depreciated, and low-yield currencies have not appreciated, to the levels predicted by © IFT. All rights reserved 4 Economics 2024 Level II High Yield Notes interest rate differentials, making it possible to earn more by investing in a higher yielding currency. Example: You can borrow dollars at 1% and earn 9% on an investment in Brazilian real for one year. To execute a carry trade: 1. Borrow dollars at t = 0, 2. Sell the dollars and buy Brazilian real at the spot rate at t = 0, 3. Invest in a real-denominated investment at t = 0, 4. Liquidate the real-denominated investment at t = 1, 5. Sell the real and buy dollars at the spot rate at t = 1, 6. Pay back the dollar loan. Balance of payments and exchange rates Current account reflects trade in goods/services; capital account reflects financial/investment flows: • Current account balance must be matched by an equal and opposite capital account balance. • Current account balance has a long-term impact on exchange rates. • Investment/financing decisions have a short-term impact on exchange rates. Flows in the balance of payment accounts affect exchange rates through the following mechanisms: The flow supply/demand channel: A current account surplus indicates high demand for the domestic currency which would cause the currency to appreciate. Over time the currency would lose its competitiveness resulting in a decline in exports and rise in imports, making the surplus hard to maintain. The opposite would be true in the case of deficits. The portfolio balance channel: Current account balances result in a shift of wealth from deficit running countries to surplus running countries. As countries with significant surpluses realize that their level of foreign reserves is much higher than required, they may attempt to reduce their foreign currency reserves, putting them under downward pressure. The debt sustainability channel: Countries that run persistent current account deficits will see their foreign debt levels rising gradually. However, there should be an upper limit to the amount of foreign debt a country can take. If investors see the foreign debt levels of a country rising to unsustainable levels, they would see a currency depreciation necessary in order to narrow the current account deficit and take the foreign debt to a more manageable level. © IFT. All rights reserved 5 Economics 2024 Level II High Yield Notes Effects of monetary and fiscal policy on exchange rates Effects of monetary and fiscal policy on exchange rates are explained through the following models: The Mundell-Fleming model: The short-term impact of monetary and fiscal policies is summarized in the tables below. High Capital Mobility Expansionary Fiscal Policy Restrictive Fiscal Policy Expansionary Monetary Policy Indeterminate Domestic currency depreciates Restrictive Monetary Policy Domestic currency appreciates Indeterminate Low Capital Mobility Expansionary Fiscal Policy Restrictive Fiscal Policy Expansionary Monetary Policy Domestic currency depreciates Indeterminate Restrictive Monetary Policy Indeterminate Domestic currency appreciates Monetary models of exchange rate determination: Monetary models assume that output is fixed and policies affect exchange rates through changes in price level and inflation. Two variations of the monetary approach are: 1. Basic monetary approach: It assumes that PPP holds at all times, therefore an increase in money supply results in an increase in inflation and a depreciation of the domestic currency. 2. Dornbusch model: As money supply increases in the short run, price levels will not increase, rather, the higher money supply will cause short-term interest rates to decline, leading to a capital outflow which in turn will cause the domestic currency to depreciate below its long-term equilibrium value. In the long run, as domestic interest rates rise, the currency will appreciate and the exchange rate will move in line with its long-term equilibrium value. The portfolio balance approach: The Mundell-Fleming model focuses on the short-run; it does not consider the long-run impact of budgetary imbalances. The portfolio balance approach addresses this limitation. This approach can be combined with the Mundell-Fleming model to determine that an expansionary fiscal policy can be positive for a currency in the short run but negative in the long run in the condition of high capital mobility. © IFT. All rights reserved 6 Economics 2024 Level II High Yield Notes As budget deficit increases in the short run, interest rates increase, bringing about capital flows and an appreciation of the domestic currency. In the long run, however, the growing budget deficit may imply the central bank may need to print more money to lend to the government and the fiscal stance may turn restrictive, which would lead to a decline in the currency's value. Exhibit 7 of the curriculum shows the short-run and long-run responses of exchange rates to changes in fiscal policy. Capital control and central bank intervention Governments often seek to control capital flows to avoid excessive flows that could quickly reverse. Governments restrict excessive capital flows by implementing capital controls and direct intervention by way of selling their currency in the FX markets. The key issue for policymakers is whether intervention and capital controls would actually work in terms of: 1. preventing currencies from appreciating too strongly 2. reducing the aggregate volume of capital inflows 3. enabling authorities to pursue independent monetary policies The effectiveness of government intervention depends on the ratio of central bank FX reserves and FX turnover. If the ratio is low (developed market) then government intervention will have low impact. © IFT. All rights reserved 7 Economics 2024 Level II High Yield Notes Warning signs of a currency crisis Certain characteristics have been observed in countries that have suffered a currency crisis: 1. Prior to a currency crisis, the capital markets have been liberalized to allow the free flow of capital. 2. There are large inflows of foreign capital (relative to GDP) in the period leading up to a crisis, with short-term funding denominated in a foreign currency being particularly problematic. 3. Currency crises are often preceded by (and often coincide with) banking crises. 4. Countries with fixed or partially fixed exchange rates are more susceptible to currency crises than countries with floating exchange rates. 5. Foreign exchange reserves tend to decline precipitously as a crisis approaches. 6. In the period leading up to a crisis, the currency has risen substantially relative to its historical mean. 7. The ratio of exports to imports (known as “the terms of trade”) often deteriorates before a crisis. 8. Broad money growth and the ratio of M2 (a measure of money supply) to bank reserves tend to rise prior to a crisis. 9. Inflation tends to be significantly higher in pre-crisis periods compared with tranquil periods. © IFT. All rights reserved 8 Economics 2024 Level II High Yield Notes LM02 Economic Growth and the Investment Decision Factors favoring and limiting economic growth Factors that enable growth include: • Savings and investment • Financial markets and intermediaries • Political stability, rule of law, and property rights • Education and health care systems • Tax and regulatory systems • Free trade and unrestricted capital flows If these factors are either absent or negative, they limit growth. Sustainable growth rate of the economy The aggregate value of the stocks can be expressed as the product of the following: E P )( ) P = GDP ( GDP E In the long run, the rate of stock market appreciation will be equal to the sustainable growth rate of the economy. The aggregate earnings to GDP ratio and P/E ratio will fluctuate but they are mean reverting variables and they will not affect the rate of stock market appreciation in the long run. Potential GDP Potential GDP is a measure of the productive capacity or output of an economy. It also represents the aggregate income of an economy. For equity investors, the best estimate for the long-term growth in earnings for a given country is the estimate of the growth rate in potential GDP. For global fixed-income investors, higher potential GDP increases the credit quality of fixed income investments. Also, the difference between the growth rate of actual and potential GDP helps predict inflation, which is a key macroeconomic variable in fixed income analysis. Capital deepening investment and technological progress Growth in per capita output can come from two sources: capital deepening and improvement in technology. © IFT. All rights reserved 1 Economics 2024 Level II High Yield Notes Capital deepening means an increase in the capital to labor ratio. It is shown by a move along the production function from point A to point B. Adding more and more capital to a fixed number of workers increases per capita output but at a decreasing rate. Technological progress, represented by an increase in total factor productivity, causes an upward shift in the entire production function. As a result, the economy can produce higher output per worker for a given level of capital per worker. This is shown by the move from B to C. Growth accounting relations Growth accounting is used to analyze the performance of economies. The growth accounting equation is as follows: ΔY/Y = ΔA/A + αΔK/K + (1 – α) ΔL/L i.e. growth rate of output = rate of technological change + α (growth rate of capital) + (1 – α) (growth rate of labor). An alternative method of measuring potential GDP is the labor productivity growth accounting equation. Under this approach, the equation for estimating the potential GDP is: Growth rate in potential GDP = Long-term growth rate of labor force + Long-term growth rate in labor productivity. The growth accounting equation is used to: 1. Estimate the contribution of technological progress 2. Measure sources of growth 3. Measure potential output © IFT. All rights reserved 2 Economics 2024 Level II High Yield Notes Natural resources Access to natural resources is important for economic growth; ownership is not. For example, countries like Japan and South Korea own few natural resources, but they were able to grow due to outside access to natural resources. Sometimes, the presence of natural resources can limit growth. • This can happen if the economic institutions of the country are not developed. • Or the country can suffer from ‘Dutch disease’ where currency appreciation makes manufacturing globally uncompetitive. Similarly, depletion of non-renewable resources does not necessarily limit growth. For example, as fossil fuel reserves are getting depleted, countries are shifting towards alternative renewable resources such as solar and wind. Demographics, immigration, and labor force participation Labor is an important source of economic growth. Growth in labor supply depends on four factors: 1. Population growth: This is determined by fertility rates and mortality rates. Population growth is high in developing countries and low in developed countries. 2. Labor force participation rate: The labor force participation rate is the percentage of the working age population in the labor force. It can increase if more women enter the workforce. 3. Net migration: Developed countries with declining labor force can encourage immigration. For example, Canada. 4. Average hours worked: Average hours worked per worker also affects the contribution of labor to the overall output. Physical capital, human capital, and technological development • • • The forces driving economic growth include the quantity and quality of labor and the supply of non-ICT and ICT capital, public capital, raw materials, and technological knowledge. Technological progress allows an economy to produce more output with the same amount of input and overcome some of the limits of diminishing marginal returns of capital. It results in an upward shift in the production function. Labor productivity is defined as output per worker or per hour worked. Growth in labor productivity depends on capital deepening and technological progress. Theories of economic growth Classical Model (also called Malthusian Theory) • Growth in real GDP per capita is temporary. • Rise in real GDP per capita above subsistence level results in a population explosion. © IFT. All rights reserved 3 Economics • 2024 Level II High Yield Notes And the real GDP per capita returns to subsistence level. Neo-Classical Model • In the steady state capital per worker and output per worker grow at equal sustainable rates. • Long-run per capita growth depends on exogenous technological progress. • Capital deepening has no impact on growth rate or on the marginal product of capital. • There will be a convergence of per capita income in developing and developed countries. Three important relationships to remember are: 1. Growth rate of output per capita = 2. Growth rate of output = θ 1−α Y θ 1−α +n 1 θ 3. Output per unit of capital = K = (s ) [(1 − α) + δ + n] Endogenous Growth Theory • Focus on explaining technological progress rather than treating as exogenous. • It states that there is no reason why incomes of developed and developing countries should converge. • A higher saving rate can lead to a permanently higher growth rate. An important relationship to remember is: ∆ye/ye = ∆ke/ke = s c – δ – n Convergence hypotheses According to the convergence hypotheses, countries with low per capita incomes should grow at a faster rate than countries with high per capita income and they will both eventually converge. The neoclassical model predicts two types of convergence: absolute and conditional. Absolute convergence implies that developing countries, regardless of their particular characteristics, will eventually catch up with the developed countries and match them in per capita output. Conditional convergence implies that convergence is conditional on the countries having the same saving rate, population growth rate and production function. If these conditions hold, the model implies convergence to the same level of per capita output as well as the same steady state growth rate. However, empirical evidence suggests that some poor countries are converging while others are not. This is explained by the club convergence hypothesis. Club convergence implies that only rich and middle-income countries that are members of © IFT. All rights reserved 4 Economics 2024 Level II High Yield Notes the club (countries which develop appropriate legal, political and economic systems; open trade and capital flow)are converging to the income level of the richest countries of the world. Countries with the lowest per capita income in the club grow at the fastest rate. However, countries outside the club without appropriate institutional structures may fall into a non-convergence trap. Private investment in technology and knowledge According to the endogenous growth theory, spending on R&D has positive externalities that benefit the whole economy. Individual companies capture only a part of the benefits associated with their R&D investments. Therefore, from a societal point of view, private companies operating with a profit motive may under-invest in R&D. Government incentives can help correct this market failure by making R&D investments more lucrative to private companies. Trade barriers In general, open and trade-oriented economies will grow faster than closed economies. Opening up the economy to trade and financial flows is likely to have the following benefits for countries: 1. Investments are not limited by domestic savings. Domestic investments can be funded by global savings. 2. Countries can focus on industries in which they have a comparative advantage. 3. Companies have access to a larger, global market; resulting in economies of scale. 4. Countries can import technology, thus increasing the rate of technological progress. 5. Increased competition from global markets forces companies to produce better products, improve productivity, and keep costs low. © IFT. All rights reserved 5 Economics 2024 Level II High Yield Notes LM03 Economics of Regulation Economic rationale for regulation Regulatory intervention is required because of the presence of • Informational frictions: Information is not equally available or distributed to all stakeholders. • Externalities: These are effects that are not captured in market prices. They can be positive (for example, public goods) or negative (for example, pollution). Regulating commerce and financial markets Purposes of regulating financial markets include: • Maintaining financial stability and promoting economic growth • Maintaining the integrity of markets and acting as a referee to ensure fairness • Mitigating agency problems The role of government in regulating commerce is to set out an underlying framework for the operation of private markets and facilitating business decisions. If rules and regulations are well-defined and well-enforced, it becomes easier for companies to make business decisions. Some issues related to regulation include: environmental issues, intellectual property, and privacy. Antitrust regulation Competition and antitrust laws prohibit abusive and anticompetitive behavior. Examples of such behavior include: • Mergers that create monopoly power • Exclusive dealings and refusals to deal • Price discrimination and engaging in predatory pricing In response to antitrust issues, regulators may not only impose monetary sanctions but may require companies to modify their business. Specifically, companies engaging in antitrust behavior might be asked to divest portions, change operating practices or change marketing practices. Also, with increasing globalization companies may need to satisfy multiple regulators. Classifications of regulations and regulators Regulators can be: • Legislative bodies: Entities that enact a statute at a broad level, leaving it to regulators to fill in the implementation details. For example, US Congress. • Government-backed regulatory bodies: They operate under the framework of the statutes to come up with detailed laws such as administrative regulations or © IFT. All rights reserved 1 Economics • 2024 Level II High Yield Notes administrative laws. They can be further classified into: o Government departments and agencies – Rely on government funding. o Independent regulators – Do not rely on government funding. Courts Regulations can be classified into: • Statutes: Laws enacted by legislative bodies. • Administrative regulations: Rules issued by government agencies or other regulators. • Judicial law: Interpretations of a court. Another classification is based on the development and enforcement of regulation. 1. Substantive law focuses on the rights and responsibilities of entities and the relationship between entities. 2. Procedural law focuses on the protection and enforcement of the substantive laws. Self- regulation in financial markets Self-regulatory bodies are private organizations that both represent and regulate their members. These entities can discipline members that violate rules and principles. While they are isolated from government pressure, they may be subject to pressure from their members. If a self-regulatory body is given recognition and authority by a government body or agency, it is called a self-regulatory organization (SRO). For example, FINRA is an SRO for all securities firms doing business in the United States. This organization has been given some regulatory authority by the US SEC. The level of authority across different SROs varies in different countries. Regulatory interdependencies • • • According to regulatory capture theory, the regulator is often dominated by individuals who are closely connected with the industry they should be regulating. Regulatory competition refers to a situation where regulators compete with each other to provide a regulatory environment designed to attract certain entities. Regulatory arbitrage is where entities may identify and use some aspect of regulations that allow them to exploit differences in regulatory interpretation. Regulatory arbitrage also includes situations where entities try to exploit differences in regulatory regimes in different regions. Regulatory tools Regulatory tools include: • the use of price mechanisms like taxes and subsidies. © IFT. All rights reserved 2 Economics • • • • 2024 Level II High Yield Notes restricting some activities (for example, insider trading and short selling). mandating some activities (for example, capital requirements for banks). providing public goods (for example, national defense, and transportation infrastructure). financing private projects that the government believes will benefit society. Regulators worry about systemic risk and financial contagion. • Systemic risk is the risk of failure of the financial system as a result of the failure of a major financial institution. • Financial contagion is a situation in which financial shocks spread from their place of origin to other healthier economies. Regulations should be predicable, efficient, consistent, and enforceable. Regulations should also help maintain a stable regulatory environment. Benefits and costs of regulation Regulatory burden refers to the costs of regulation for the regulated entity. Net regulatory burden is the private cost of regulation less the private benefits of regulation. A cost-benefit analysis should be conducted before any new regulation is implemented. Regulators should consider both the implementation costs of regulation as well as the indirect costs. Post implementation, the actual costs and benefits should be compared with the expected costs and benefits. This ‘retrospective analysis’ allows for a more informed assessment of whether any changes need to be made to the regulation. Regulators can also make use of ‘regulatory sandboxes’, where new regulation is first tested in a sandbox environment, for example, a subset of an industry, before being implemented for the whole industry. Analysis of regulation Analysts should be able to understand and anticipate the impact of proposed new or changing regulations on the future prospects for companies and industries. For example, Regulation Q in 1970s put a restriction on the amount of interest that banks could pay its depositors. This was a boon for money market mutual funds as a lot of money moved into these funds. Common steps to evaluate the impact of regulation include: • Assessment of the likelihood of regulatory change – The analyst should determine the probability of the regulatory change being implemented. • Assessment of the impact of regulatory change on a sector – The analyst can determine the impact of a new regulation by looking at the following: © IFT. All rights reserved 3 Economics 2024 Level II High Yield Notes o Impact on revenues – for example, limits on prices, tariffs, rents, or fees that companies charge may be introduced. o Cost impact – for example, increased manufacturing costs to incorporate new safety features. o Business risk – for example, fines, requirements to pay compensation to customers, or bans on certain activities. © IFT. All rights reserved 4