1. August 8, 2015Foreign Exchange Determination1 Forecasting exchange rates Foreign Exchange Determination

2. August 8, 2015Foreign Exchange Determination2 Forecasting (fundamental analysis)  fundamental analysis Theoretical analysis  Purchasing power parity balance of payments  Cash flow analysis monetary & fiscal policies  Stock analysis regulatory policies  Trade policies political risk

3. Theoretical analysis  Purchasing power parity Assuming efficient markets  Real world prices converge Measurement problems  Market baskets used to measure inflation are not consistent  Fisher effect  Interest rate parity August 8, 2015Foreign Exchange Determination3

4. Parity conditions August 8, 2015Foreign Exchange Determination4 Purchasing Power Parity Fisher effect International Fisher effect Interest rate parity Unbiased predictor

5. Parity conditions August 8, 2015Foreign Exchange Determination5  For parity to hold efficient market conditions needed  Thick markets many buyers, many sellers  Perfect information  Low or no market frictions Transactions costs Taxes, tariffs  May be most useful pointing to the existence of frictions in the market

6. Balance of payments August 8, 2015Foreign Exchange Determination6  Cash flow analysis Current acct, capital acct, financial acct, reserve acct Relative demands and supplies of dollars in the exchange markets  Function of real cash flows to pay for Trade in goods, services, transfers FDI, investment in real assets Portfolio investment, investment in financial assets

7. Monetary August 8, 2015Foreign Exchange Determination7  Changes in supply and demand for money BOP tracks the foreign exchange as a medium of exchange (flow) Store of wealth (stock)  Demand for dollars to hold  Moderates BOP influences China holding dollar assets  Other currencies are substitutes Moving from dollar reserves to euro reserves

8. August 8, 2015Foreign Exchange Determination8 Central Bank affects on liquidity  cash & currency directly supplied by CB  checking accounts & debit cards money multiplier determined CB directly affects the multiplier  reserve requirements  capital requirements  credit cards availability of credit indirectly affected by CB

9. August 8, 2015Foreign Exchange Determination9 Factors affecting money & exchange rates  economic growth economic growth increases demand for base  inflation CB controls the supply of base money  interest rates CB controls the bank rate directly CB influences term structure of interest rates indirectly  political risk

10. August 8, 2015Foreign Exchange Determination10 Economic Growth  Growth increases the demand for money demand for money curve shifts up  Assume CB keeps money supply constant no change in the vertical supply curve  the value of money increases prices and value of money inversely related domestically - deflation internationally - exchange rate appreciation

11. August 8, 2015Foreign Exchange Determination11 Money Supply  Central Bank increases supply of money supply curve shifts out  Assuming no change in demand for money the demand for money curve remains stationary  the value of money decreases prices and value of money inversely related domestically - inflation internationally - exchange rate depreciation

12. Asset market August 8, 2015Foreign Exchange Determination12  Bonds, stocks, currencies are close substitutes Changes in demand for financial assets (other than money)  Portfolio diversification South American investors Saudia Arabian investors  Capital flight  Seeking efficient markets Properly priced financial assets

13. August 8, 2015Foreign Exchange Determination13 Term Structure of Interest Rates Term to maturity iTiT New term structure of interest rates after CB increases bank rate

14. August 8, 2015Foreign Exchange Determination14 Shift in Term Structure of Interest Rates  Central bank changes the bank rate only rate directly controlled by CB least risky rate in the economy  no default risk  little interest rate risk - overnight funds rate  other rates will ratchet up relative to risk  default - ability to pay  interest rate risk - relative to term to maturity

15. August 8, 2015Foreign Exchange Determination15 Jump Shift in Term Structure Term to maturity iTiT Jump in term structure after a large change in political risk

16. August 8, 2015Foreign Exchange Determination16 Jump Shift in Term Structure  Small change in power structure new rules some increase in uncertainty about future small discrete change in market risk premium  Large change in power structure systemic change in the economy large increase in uncertainty about future large discrete change in market risk premium

17. August 8, 2015Foreign Exchange Determination17 Political risk (anticipated)  Fiscal policies taxes, expenditures deficit and debt policies  Monetary policies relative inflation, interest rates exchange rate (foreign reserves, intervention  Regulatory policies trade restrictions capital controls

18. August 8, 2015Foreign Exchange Determination18 Political risk (unanticipated)  Political risk probability of change in government probability of change in direction external threats  crime  war  Differences between markets official markets unofficial markets (grey & black markets)

19. August 8, 2015Foreign Exchange Determination19 Technical Analysis  technical analysis  Time series analysis trends correlation

20. August 8, 2015Foreign Exchange Determination20 Political Risk  party in power makes the rules distribution of income and wealth  tax law  transfers regulatory environment  increase or decrease frims’ costs of doing business  change of party in power change in the rules  for example PQ in power in Québec

21. August 8, 2015Foreign Exchange Determination21 Capital Asset Pricing System i M the market rate increases as the market becomes more risky i M - i rf the market risk premium also increases  I measure of risk increases with market volatility

22. August 8, 2015Foreign Exchange Determination22  gold  silver  cd denominated t- bills  foreign currency denominated t-bills  cash  currency  chartered bank reserves held at the Bank of Canada Bof C buys US dollars as an asset Canadian dollar liability increases Unsterilized Intervention

23. August 8, 2015Foreign Exchange Determination23 Domestic Affects of an Unsterilzed Intervention  Base money increases by amount of purchase  pressure exerted on prices to increase inflation in the economy Canadian goods cost more in cd

24. August 8, 2015Foreign Exchange Determination24 Foreign Affects of an Unsterlized Intervention  short run exchange rate is not allowed to adjust  long run higher Canadian inflation  US goods cost relatively less to Canadians  Canadian goods cost relatively more to US consumers exchange rate remains relatively constant

25. August 8, 2015Foreign Exchange Determination25  gold  silver  cd denominated t- bills  foreign currency denominated t-bills  cash  currency  chartered bank reserves held at the Bank of Canada B of C sells equal value in other assets Bof C buys US dollars as an asset No increase in B of C liabilities Sterlized Intervention

26. August 8, 2015Foreign Exchange Determination26 Domestic Affects of an Sterilzed Intervention  Base money remains constant  prices remain constant

27. August 8, 2015Foreign Exchange Determination27 Foreign Affects of an Sterlized Intervention  short run exchange rate is not allowed to adjust  long run pressure remains on exchange rate to depreciate  BOT deficit remains  eventually the cd price of the usd will increase

28. August 8, 2015Foreign Exchange Determination28 BOT (Current Account) Deficit  currency depreciation higher prices for imports lower prices for exports  protectionism tariffs, quotas, import restrictions  capital controls restrict foreign ownership  exchange market intervention

29. August 8, 2015Foreign Exchange Determination29 Covered Interest Arbitrage  Borrow 100,000 cd @ 6.75%  Buy 66,339.39 usd spot at 1.5074  Lend 66,339.39 for one year @ 7.75%  Buy 107,585.59 cd forward @ 1.5051  collect loan of 71,480.69 usd  take delivery of forward contract  pay off loan of 106,750 cd  riskless return of 835.59 cd