Currency Exchange Rates: Understanding Equilibrium Value

CFA Level 2 | Economics | Learning Module 1

Foreign Exchange Market Concepts

Exchange rates represent the price of a base currency in terms of a price currency. Notation is not standardized.
The spot exchange rate is for immediate settlement (typically T+2, except CAD/USD at T+1).
Market participants are quoted a bid price (price at which the dealer buys the base currency) and an offer (ask) price (price at which the dealer sells the base currency).
The bid-offer spread (offer price – bid price) is the dealer’s compensation.
Factors affecting the bid-offer spread include the currency pair (major pairs have tighter spreads), time of day (overlap of major trading centers leads to tighter spreads), market volatility (higher volatility widens spreads), transaction size (larger transactions may get tighter spreads), and the dealer-client relationship.
Triangular arbitrage involves exploiting inconsistencies in quoted exchange rates among three currencies to make a riskless profit. Arbitrage opportunities arise if a dealer’s posted bid is higher than the interbank offer or the posted offer is lower than the interbank bid.
Implied cross rates can be calculated from two exchange rates involving a common currency (e.g., GBP/EUR from GBP/USD and USD/EUR). Arbitrage ensures that the dealer’s cross-rate bids and offers are consistent with implied rates.

Forward Markets

Outright forward contracts are agreements to exchange currencies at a future date at a rate agreed upon today (settlement date longer than T+2).
A forward premium exists if the forward rate is higher than the spot rate for the base currency; a forward discount exists if the forward rate is lower.
Covered interest rate parity (CIP) is a no-arbitrage condition where a hedged foreign investment yields the same return as a domestic investment.
Forward rates in professional markets are often quoted as forward points, which are the difference between the forward and spot rates, scaled (e.g., divided by 10,000 or 100 for JPY). These points are added to the spot bid or offer to get the all-in forward bid or offer.
The mark-to-market (MTM) value of a forward contract represents the profit or loss if the position were closed out at current market prices. It is calculated by creating an offsetting forward position, determining the all-in forward rate for that position, calculating the settlement cash flow, and then discounting that cash flow to the present using the appropriate discount rate.
Factors affecting forward bid-offer spreads are the same as for spot spreads, plus the term of the forward contract (longer terms generally have wider spreads).

International Parity Conditions

International parity conditions describe the theoretical long-run relationships between exchange rates, interest rates, and inflation rates.
Covered Interest Rate Parity is enforced by arbitrage.
Uncovered Interest Rate Parity states that the expected change in the spot exchange rate equals the interest rate differential between two countries. It assumes risk-neutral investors and may not hold in the short to medium term.
Forward Rate Parity suggests that the forward exchange rate is an unbiased predictor of the future spot exchange rate. This holds if both Covered Interest Rate Parity and Uncovered Interest Rate Parity hold.
Purchasing Power Parity (PPP) relates exchange rates to relative price levels and inflation.
Law of One Price: Identical goods should trade at the same price across countries when priced in a common currency.
Absolute PPP: The nominal exchange rate is determined by the ratio of national price levels: Sf/d = Pf / Pd. Rarely holds in reality due to transaction costs and non-tradable goods.
Relative PPP states that the expected percentage change in the spot exchange rate is approximately equal to the difference between the expected foreign and domestic inflation rates. PPP tends to hold better over the long run.
Ex Ante PPP: Expected changes in the spot rate are driven by expected inflation differentials: E(%ΔSf/d) = E(πf) – E(πd).
The International Fisher Effect posits that nominal interest rate differentials reflect expected inflation differentials. It implies that real interest rates are equal across countries (real interest rate parity) if Uncovered Interest Rate Parity and PPP hold.

Relations Among International Parity Conditions

Covered Interest Rate Parity is a no-arbitrage condition.
Forward Rate Parity requires both Covered Interest Parity and Uncovered Interest Parity to hold.
The forward premium/discount is determined by nominal interest rate differentials due to Covered Interest Rate Parity.
If all key parity conditions hold, the expected percentage change in the spot exchange rate would equal the forward premium/discount, the nominal yield spread, and the expected inflation spread.

The Carry Trade

A carry trade involves borrowing in a low-yield currency and investing in a high-yield currency.
The profit from a carry trade comes from the interest rate differential and any appreciation of the high-yield currency (or smaller-than-expected depreciation).
The carry trade is profitable when uncovered interest rate parity does not hold.
Carry trades have crash risk due to the potential for sudden adverse exchange rate movements leading to large losses, especially during periods of high volatility. The return distribution tends to have fat tails and a negative skew.
Carry trades are often leveraged, which increases the volatility of returns.

The Impact of Balance of Payments Flows

A country’s balance of payments (BOP) includes the current account (trade in goods and services) and the capital and financial account (investment and financing flows).
Current account imbalances can affect exchange rates through the flow supply/demand channel, the portfolio balance channel, and the debt sustainability channel. Persistent deficits can lead to currency depreciation, while surpluses can put upward pressure on the currency.
Capital flows, driven by factors like interest rate differentials and risk perceptions, can have a significant short-term impact on exchange rates. Large and sudden capital inflows can lead to asset bubbles and currency overvaluation, followed by potential reversals and crises.

Monetary and Fiscal Policies

The Mundell-Fleming model analyzes the short-run impact of monetary and fiscal policies on interest rates, economic activity, capital flows, trade, and exchange rates, considering the degree of capital mobility.
- With high capital mobility, restrictive monetary policy or expansionary fiscal policy (leading to higher real rates) tends to cause currency appreciation. Expansionary monetary policy or restrictive fiscal policy (leading to lower real rates) tends to cause depreciation.
- With low capital mobility, expansionary monetary and fiscal policies together tend to cause currency depreciation due to increased imports. Restrictive monetary and fiscal policies tend to cause appreciation due to reduced imports.
Monetary models of exchange rate determination emphasize the role of money supply and price levels, assuming PPP holds. An increase in domestic money supply is expected to lead to a proportional decrease in the domestic currency’s value.
The portfolio balance approach focuses on the long-term effects of government budget deficits and the resulting increase in the supply of domestic bonds. Persistent large deficits may eventually lead to currency depreciation as investors demand higher returns.

Exchange Rate Management: Intervention and Controls

Central banks or governments may intervene in the foreign exchange market to influence exchange rates and reduce volatility. Intervention can involve buying or selling their own currency.
Capital controls are measures to limit the flow of capital across borders. Objectives include preventing excessive inflows or outflows, managing exchange rates, and allowing for independent monetary policy. Their effectiveness is debated, and they can lead to the development of black markets.

Warning Signs of a Currency Crisis

Several indicators may signal an increased likelihood of a currency crisis:
- Capital market liberalization followed by large capital inflows, especially short-term foreign currency denominated debt.
- Banking crises often precede or coincide with currency crises.
- Fixed or partially fixed exchange rates are more vulnerable.
- Precipitous decline in foreign exchange reserves.
- Substantial appreciation of the currency relative to its mean.
- Deterioration in the terms of trade (export/import ratio).
- Rising broad money growth and M2 to bank reserves ratio.
- Significantly higher inflation.
Currency crises can occur suddenly and may not always be predicted by economic fundamentals due to shifts in market sentiment and contagion effects.
Early warning systems aim to identify these vulnerabilities but are not foolproof and can generate false alarms.