Exchange rate movements
Exchange rates can be free-floating or fixed. A free-floating exchange rate rises and falls due to
changes in the foreign exchange market. A fixed exchange rate is pegged to the value of another
currency. The Hong Kong dollar is pegged to the U.S. dollar in a range of 7.75 to 7.85, so the value of
the Hong Kong dollar to the U.S. dollar will remain within this range.3
Exchange rates have a spot rate or cash value that’s the current market value. They may also have a
forward value that’s based on expectations for the currency to rise or fall vs. its spot price.
Forward rate values fluctuate due to changes in expectations for future interest rates in one country
vs. another. Traders may buy the dollar vs. the euro if they speculate that the eurozone will ease
monetary policy vs. the U.S., causing a downward trend in the value of the euro.
Exchange rate equilibrium
The equilibrium exchange rate is the price of one currency in terms of another when the quantity of
that currency demanded equals the quantity supplied, similar to a market equilibrium. It is
determined by the intersection of the currency's supply and demand curves on a foreign exchange
market. At this rate, there is no surplus or shortage of the currency, and it is considered a
sustainable or "fair" value for the currency over the long term.
Factors affecting Foreign Exchange Rate
INFLATION RATES
Currency exchange rates are affected by changes in market inflation. The value of a country's
currency will appreciate if its inflation rate is lower than that of another. When inflation decreases,
prices of goods and services rise at a moderate [Link], Germany, and Switzerland had low
inflation in the final part of the twentieth century, but the United States and Canada did not reach
low inflation until much later. Countries with greater inflation generally saw their currencies
depreciate against their economic ties' currencies. Higher interest rates are frequently associated
with [Link]'s say a company in the United States and a company in the United Kingdom both sell
alternative items. If UK inflation rises but US inflation remains unchanged, UK demand for US goods
will rise, as will UK demand for US currencies. Furthermore, demand for UK goods in the United
States will fall, reducing the supply of US dollars. The supply curve will shift leftward due to reduced
supply, while the demand curve will shift rightward due to higher demand. The new equilibrium rate
will then be greater than the current rate.
INTEREST RATES
Interest rates, inflation, and currency exchange rates are all intertwined. Central banks control
inflation and exchange rates through managing interest rates, and changing interest rates affects
inflation and currency values. Higher interest rates provide a better return to lenders in a given
economy than in other countries. As a result, higher interest rates entice foreign capital and drive up
the currency [Link] that the UK interest rate rises while the US rate remains unchanged. In
this circumstance, investors in the United Kingdom are likely to cut their demand for dollars. UK
rates are currently more appealing, and US institutions require fewer deposits. Because UK rates are
now more appealing, US investors with extra cash will boost the amount of dollars available for sale
in order to invest in the UK. The equilibrium exchange rate will fall due to the inward shift of dollar
demand and the outward shift of dollar supply.
INCOME LEVELS
The amount of import demand and the exchange rate are both influenced by one's income level.
Assume that the UK's income level rises while the US's income level remains fixed. As a consequence
of the increase in UK income and higher demand for US goods, the demand curve will shift upward.
The supply schedule, on the other hand, is unlikely to [Link] a result of this, the equilibrium
exchange rate has risen.
GOVERNMENT CONTROLS
Variations inflation expectations have an impact on international trade, which effects currency
demand and supply, and thus exchange rates. Let's say a company in the United States and a
company in the United Kingdom both sell alternative items. If UK inflation goes up but US inflation
remains unchanged, UK demand for US goods will rise, as will UK demand for US currencies.
Furthermore, desire for UK goods in the United States will fall, reducing the supply of US dollars. The
supply curve will shift leftward due to reduced supply, while the quantity demanded will shift
rightward due to higher demand. The new equilibrium rate will then be greater than the current
rate.
FUTURE EXCHANGE RATE EXPECTIONS
The factor that determines the exchange rate is future exchange rate forecasts. Foreign exchange
markets, as with all financial markets, respond to news that has the potential to have long-term
consequences. The authorities can influence the exchange rate by increasing or decreasing [Link]
word to circulate in the United States that inflation will rise in the near future. It will cause traders to
sell US dollars, resulting in a rise in supply. Demand, on the other hand, will have no bearing. As a
result, supply will be reduced, resulting in a reduction in the exchange rate. However, if word of
deflation in the United States spreads, traders will buy US dollars in order to buy all of the US dollars
on the market, raising US dollar demand. The supply, on the other hand, will remain unchanged. The
equilibrium exchange rate will rise as a result of this.
CURRENT ACCOUNT DEFICIT
The current account is a country's trade balance with its trade agreements, representing all
payments for goods, services, interest, and dividends made between countries. A current account
deficit indicates that the country is spending more on foreign trade than it is earning, and that it is
borrowing money from other countries to cover the [Link] extra demand for foreign currency
lowers the home currency's exchange rate in exchange for foreign currency, resulting in foreigners
paying less for domestic commodities.
PUBLIC DEBT AND TAX
To pay for public initiatives and government subsidies, countries will participate in large-scale deficit
financing. Whereas this activity boosts the economy at home, countries with huge public deficit
spending are less appealing to foreign owners. A huge debt fosters inflation, and if inflation
increases, the loan will be paid and eventually paid off with less expensive real [Link] in tax
rates cause money to flow in and out of the [Link] cuts have a considerable expansionary
influence on macroeconomic indicators, according to empirical research. Tax cuts for individuals and
businesses boost production, development, employment, and demand.
TERMS OF TRADE
The conditions of commerce are another key aspect that influences a country's exchange rate. When
a country's exports exceed its imports, trade is considered to be positive. However, if the converse
occurs, the situation is not beneficial. When export conditions improve, the country's goods are in
high demand outside of the country, indicating higher currency demand. As a result, that nation's
exports appreciate.
Interest Rate Parity (IRP)
Interest rate parity is an economic concept, expressed as a basic algebraic identity that relates
interest rates and exchange rates. The identity is theoretical, and usually follows from assumptions
imposed in economic models. There is evidence to support as well as to refute the concept. Interest
rate parity is a non-arbitrage condition which says that the returns from borrowing in one currency,
exchanging that currency for another currency and investing in interest-bearing instruments of the
second currency, while simultaneously purchasing futures contracts to convert the currency back at
the end of the holding period, should be equal to the returns from purchasing and holding similar
interest-bearing instruments of the first currency. If the returns are different, an arbitrage
transaction could, in theory, produce a risk-free return. Looked at differently, interest rate parity
says that the spot price and the forward or futures price of a currency incorporate any interest rate
differentials between the two currencies. According to interest rate parity the difference between
the (risk free) interest rates paid on two currencies should be equal to the differences between the
spot and forward rates.
If interest rate parity is violated, then an arbitrage opportunity exists. The simplest example of this is
what would happen if the forward rate was the same as the spot rate but the interest rates were
different, than investors would:
1. Borrow in the currency with the lower rate.
2. Convert the cash at spot rates.
3. Enter into a forward contract to convert the cash plus the expected interest at the same rate.
4. Invest the money at the higher rate.
5. Convert back through the forward contract.
6. Repay the principal and the interest, knowing the latter will be less than the interest received.
Types of Interest Rate Parity (IRP)
Covered Interest Rate Parity
Assuming the arbitrage opportunity described above does not exist, then the relationship for US
dollars and pounds sterling is:
(1 + r£)/ (1 + r$ ) = (£/$f )/(£/$s )
Where r£ is the sterling interest rate (till the date of the forward), r$ is the dollar interest rate,
£/$ is the forward sterling to dollar rate,
£/$s is the spot sterling to dollar rate
Unless interest rates are very high or the period considered is long, this is a very good
approximation:
r£ = r$ + f
where f is the forward premium: (£/$f )/(£/$s ) – 1
The above relationship is derived from assuming that covered interest arbitrage opportunities
should not last, and is therefore called covered interest rate parity.
Uncovered Interest Rate Parity
Assuming uncovered interest arbitrage leads us to a slightly different relationship:
r = r2 + E[∆S]
Where E[∆S] is the expected change is exchange rates.
This is called uncovered interest rate parity.
As the forward rate will be the market expectation of the change in rates, this is equivalent to
covered interest rate parity – unless one is speculating on market expectations being wrong. The
evidence on uncovered interest rate parity is mixed.
Purchasing Power Parity (PPP)
The PPP theory focuses on the inflation-exchange rate relationships. If the law of one price were true
for all goods and services, we could obtain the theory of PPP. There are two forms of the PPP theory.
Absolute Purchasing Power Parity
The absolute PPP theory postulates that the equilibrium exchange rate between currencies of two
countries is equal to the ratio of the price levels in the two nations. Thus, prices of similar products
of two different countries should be equal when measured in a common currency as per the
absolute version of PPP theory.
A Swedish economist, Gustav Cassel, popularised the PPP in the 1920s. When many countries like
Germany, Hungary and Soviet Union experienced hyperinflation in those years, the purchasing
power of the currencies in these countries sharply declined. The same currencies also depreciated
sharply against the stable currencies like the US dollar. The PPP theory became popular against this
historical backdrop.
Let Pa refer to the general price level in nation A, Pb the general price level in nation B and Rab to
the exchange rate between the currency of nation A and currency of nation B. Then the absolute
purchasing power parity theory postulates that
Rab = Pa /Pb
For example, if nation A is the US and nation B is the UK, the exchange rate between the dollar and
the pound is equal to the ratio of US to UK Prices. For example, if the general price level in the US is
twice the general price level in the UK, the absolute PPP theory postulates the equilibrium exchange
rate to be Rab = $2/£1.
Relative Purchasing Power Parity
The relative form of PPP theory is an alternative version which postulates that the change in the
exchange rate over a period of time should be proportional to the relative change in the price levels
in the two nations over the same time period. This form of PPP theory accounts for market
imperfections such as transportation costs, tariffs and quotas. Relative PPP theory accepts that
because of market imperfections prices of similar products in different countries will not necessarily
be the same when measured in a common currency.
Specifically, if subscript ‘0’ refers to the base period and ‘1’ to a subsequent period then relative PPP
theory postulates that
where Rab1 and Rab0 refer to the exchange rates in period 1 and in the base period respectively. If
the absolute PPP were to hold true, the relative PPP would also hold. However, the vice versa need
not hold. For example, obstructions to the free flow of international trade like transportation costs,
existence of capital flows, government intervention policies, etc. would lead to the rejection of the
absolute PPP. However, only a change in these factors would lead to the rejection of the relative
PPP.
International Fisher Effect (IFE)
The IFE uses interest rates rather than inflation rate differential to explain the changes in exchange
rates over time. IFE is closely related to the PPP because interest rates are significantly correlated
with inflation rates. The relationship between the percentage change in the spot exchange rate over
time and the differential between comparable interest rates in different national capital markets is
known as the ‘International Fisher Effect.’
The IFE suggests that given two countries, the currency in the country with the higher interest rate
will depreciate by the amount of the interest rate differential. That is, within a country, the nominal
interest rate tends to approximately equal the real interest rate plus the expected inflation rate.
Both, theoretical considerations and empirical research, had convinced Irving Fisher that changes in
price level expectations cause a compensatory adjustment in the nominal interest rate and that the
rapidity of the adjustment depends on the completeness of the information possessed by the
participants in financial markets. The proportion that the nominal interest rate varies directly with
the expected inflation rate, known as the ‘Fisher effect, has subsequently been incorporated into the
theory of exchange rate determination. Applied internationally, the IFE suggests that nominal
interest rates are unbiased indicators of future exchange rates.
In an expectational sense, a country’s real interest rate is its nominal interest rate adjusted for the
expected annual inflation rate. It can be viewed as the real amount by which a lender expects the
value of the funds lent to increase on an annual basis. For a firm using its own funds, it can be
viewed as the expected real cost of doing so. The nominal interest rate consists of a real rate of
return and anticipated inflation. The nominal interest rate would also incorporate the default Notes
risk of an investment.
It is often argued that an increase in a country’s interest rates tends to increase the exchange value
of its currency by inducing capital inflows. However, the IFE argues that a rise in a country’s nominal
interest rate relative to the nominal interest rates of other countries indicates that the exchange
value of the country’s currency is expected to fall. This is due to the increase in the country’s
expected inflation and not due to the increase in the nominal interest rate.
Arbitrage Definition:
It involves no risk and no capital of your own. It is an activity that takes advantages of pricing
mistakes in financial instruments in one or more markets. That is, arbitrage involves (1) Pricing
mistake (2) No own capital (3) No Risk
Note: The definition we used presents the ideal view of (riskless) arbitrage. “Arbitrage,” in the real
world, involves some risk (the lower, the closer to the pure definition of arbitrage). We will call this
arbitrage pseudo arbitrage.
There are 3 types of arbitrage:
(1) Local (sets uniform rates across banks) (
2) Triangular (sets cross rates)
(3) Covered (sets forward rates)
Local Arbitrage (One good, one market)
It sets the price of one good in one market. Law of one price: the same good should trade for the
same price in the same market.
Example: Suppose two banks have the following bid-ask FX quotes:
Bank A Bank B
USD/GBP 1.50 1.51 1.53 1.55
Taking both quotes together, Bank A sells the GBP too low relative to Bank B’s prices. (Or,
conversely, Bank B buys the GBP too high relative to Bank A’s prices). This is the pricing mistake!
Triangular Arbitrage (Two related goods, one market)
Triangular arbitrage is a process where two related goods set a third price. In the FX Market,
triangular arbitrage sets FX cross rates. Cross rates are exchange rates that do not involve the USD.
Most currencies are quoted against the USD. Thus, cross-rates are calculated from USD quotations –
i.e., the most liquid quotes.
The cross-rates are calculated in such a way that arbitrageurs cannot take advantage of the quoted
prices. Otherwise, triangular arbitrage strategies would be possible.
Covered Interest Arbitrage (Four instruments -two goods per market-, two markets)
When a trader uses a forward contract to hedge against the exchange rate risk while investing in a
higher-yielding currency, it is known as covered interest arbitrage. In a covered interest arbitrage,
the word ‘cover’ means to hedge against fluctuations in the exchange rate and ‘interest arbitrage’
means to take advantage of an interest rate differential. Covered interest arbitrage is complex
trading manoeuvres and requires sophisticated setups.