Archive for February, 2008
CFA: Foreigh Exchange Parity Relations (19)
I’ve been slacking a bit and sick so I haven’t been posting as much as before. This should change soon. Here we have a pretty thick LOS that has some basic formulas but lots of concepts and discussion. There’s definitely a lot to remember here so good luck.
LOS 19a: explain how exchange rates are determined in a flexible or floating exchange rate system
this is generally the way the price changes for anything else in a free-market economy: supply and demand. the supply and demand of the domestic economy determines the exchange rate in a floating exchange rate system. this is differentiated from pegged or fixed exchange rate systems where the gov’t controls the exchange rate purposely for political or other financial reasons.
the supply and demand factors in this situation are based on the amount imported/exported. the idea is that there is an equilibrium that can be assumed is the current exch rate, and sudden changes in that exch rate will change the demand and therefore affect the supply. say we are talking about the USD/EUR spot rate, which is currently around $1.4, which means that $1.4 USD will buy 1 EUR. if the exch rate increases to say $1.6 suddenly, then the demand for EUR decreases proportionately and the supply increases the same amt. this would mean that people in the US who are buying European good/svcs will have to pay more USD for those goods that are priced in EUR. when you buy goods priced in EUR, you are in effect selling USD and buying EUR in order to do a EUR denominated transaction. the increase in the exch rate would create a surplus of EUR and negative price pressure on USD, making goods/svcs denominated in USD cheaper and thus more attractive to folks who earn income in EUR. people buying more USD denominated goods would then create positive price pressure on USD, bringing exch rate closer to $1.4 where it was before and thus closer to it’s prior equilibrium. this is the normal ebb and flow of anything really and how prices change in relationship between supply and demand.
in reality, after exch rates change unexpectedly, there are actually a lot of other factors that will be addressed in these following LOS, but these ideas are constrained to answering this LOS.
LOS 19b: explain the role of each component of a balance-of-payments accounts
this is similar to LOS 17a but doesn’t really mention anything about the reserve or settlements account that trues-up the deficit and/or surplus. except for one sentence that states, “the official reserve account tracks all reserve transactions by the monetary authorities,” its not described in detail. the deficit/surplus from one should offset the deficit/surplus of the other. when it doesn’t, it is basically the amt that prevents the balance-of-payments from being zero.
current account: all current transactions that take place in the normal business of residents of a country. it is denominated by the trade balance, the balance of all exports and imports. it also includes various other current transactions. the transactions included are:
- exports and imports (the trade balance, which is a net of the two)
- services (transportation, communication, insurance, and finance)
- income (interest, dividends, and various investment income from cross-border investments)
- current transfers (gifts or other flows without quid pro quo compensation like foreign aid)
the current account represents the net value of all of these flows associated with current transactions by residents abroad or by nonresidents in the home country.
financial account: this includes investments by residents abroad and investments by nonresidents in the home country. the transactions included are:
- direct investment made by companies
- portfolio investments in equity, bonds, and other securities of any maturity
- other investments and liabilities (such as deposits or borrowing with foreign banks and vice-versa)
the financial account represents the net of all of these transactions/flows.
the sum of these 2 accounts is called the overall balance. And this balance should always equal zero. if the balance is not zero, then the monetary authority of that country has to reserve the difference to fill in the gap.
LOS 19c: explain how current account deficits or surpluses and financial account deficits or surpluses affect an economy
current account deficits are usually caused by trade deficits (exports - imports) which occurs when a country exports more than it imports, or put another way, consuming more than it is producing. a country that consumes more than it produces needs to maintain its consumption somehow, and must import goods in order to maintain that level of consumption. if this situation does occur, then there has to be a financial account surplus to offset the current account deficit. so there has to be a net inflow of money into the country that in effect, finances the current account deficit.
from an exch rate point of view, the current account deficit puts depreciation pressure on the currency, but the financial surplus puts appreciation pressure on the currency, so they should both cancel each other out.
the current account deficit isn’t necessarily a bad thing unless suddenly foreign investment stops and there is no financial account surplus to offset the deficit. the magnitude of the current account deficit also plays a role and makes the situation more extreme - and the resulting adjustment very painful if foreign investment does indeed stop. the text has a great metaphor to help explain this. in any growing corporation’s capital structure, there is inevitably some amount of external financing. now, if a corporation has a growing need for external financing, to the point that it can’t sustain itself without it (for example, distressed debt investors and distressed companies), then the situation can become bad and the issue of sustainability becomes a large factor. for current account deficits, a country that is growing faster than other countries in the world will inevitably have a current account deficit, but as long as that country maintains an attractive and stable investment environment and the magnitude of the deficit is manageable, then a current account deficit is fine and normal. but getting outside of that with large deficits and local instability can make a deficit a caustic and generally very bad thing.
LOS 19d: describe the factors that cause a nation’s currency to appreciate or depreciate.
- differences in national inflation rates: basically the prices of domestically priced goods changing at different rates than the prices of domestic goods in foreign countries will cause the currency to depreciate. as local goods/svcs require more local currency to buy, it causes the local currency to depreciate relative to other global currencies if the same changes in prices are not realized at the same time.
- changes in real interest rates: this is basically the same idea except this is the price of money. as the real interest rate increases, so does the value of the currency. this real interest rate is the difference between nominal interest rates minus the amount of expected inflation.
- differences in economic performance: this is the difference between current and long-term growth propects and also in relation to other foreign countries. as described earlier, high-growth nations will typically have current account deficits that are offset by financial account surpluses because the nation’s consumption is above and beyond what it can produce and has to import goods in order to keep up. unfortunately, other nations in the world can’t necessarily keep up this same level of production or consumption so rates of change of both exports and imports are not the same. a country’s current growth rate is usually reflected in the current account. investment in a country’s growth is usually determined by long-term growth prospects or put another way, expected returns. subsequently, a country’s long-term potential growth is reflected in the financial account. the text states that the long-term vs short-term prospects are generally unclear as to the net effect on currency, because financial account surpluses are supposed to negate the effects of current account deficits. however the net effect should result in a stable currency, but this is inconclusive and unclear as to the absolute effects of changes in growth rates and should probably be taken on a case-by-case basis.
- changes in investment climate: high expected returns can also accompany high risk or some level of risk. this mix will of course determine the amount of capital that is invested into a country. good news will result in currency appreciation typically because there are higher capital inflows. some of the attributes of a solid investment climate are: stable political system, rigorous but fair legal system to protect investors, tax system that is fair to foriegn investors, free movements of capital, and monetary authorities that favor price stability.
LOS 19e: explain how monetary and fiscal policies affect the exchange rate and balance-of-payments components
expansionary monetary policy (decrease in interest rates) makes the real interest rate temporarily drop and causes upward price pressure and thus inflation. this is assuming that this is sudden and unexpected. generally, this is a short-term fix and will not likely be long-lived, the current account will realize a change but its unlikely that the financial account will since the financial account is typically driven off of long-term expected returns. therefore, exansionary policy will lead to a depreciation of the home currency while a restrictive policy will do the opposite.
expansionary fiscal policy (everything else equal) means that the gov’t is reducing taxes while increasing the budget deficit while a restrictive fiscal policy is where the gov’t is increasing taxes. a more restrictive fiscal policy implies less gov’t borrowing, which should induce a reduction of the domestic interest rate. a decrease in the domestic interest rate should cause the home currency to depreciate. however, more taxes generally means less spending and less growth, which causes the home currency to appreciate. the net result is usually dependent on the interest rate effects of monetary policy (most economists agree), but the text says that its generally inconclusive as to what the outcome really is. generally, the text does say that restrictive fiscal policy should lead to depreciation of the home currency while expansionary fiscal policy should lead to appreciation.
LOS 19f: describe a fixed exchange rate and a pegged exchange rate system
fixed exchange rate: in this type of regime, the exch rate is fixed against another currency permenantly. this is called official parity. usually there is a currency board that determines the rate and also reserves of the domestic and foreign money supplies. in a fixed exch rate, there is usually some kind of backing of the home currency that could be gold or another country’s currency. this backing is managed through the balance of payments process by the currency board.
pegged exchange rate: this type of regime is a type of fixed and floating exch rate. the home currency is paired or “pegged” against another major currency or basket of currencies. the rate that it is pegged at is not an absolute rate, but a flexible rate that can move within a band around a target exch rate. the home country usually makes periodic evaluations as to whether the target needs to change or remain the same depending on inflationary or other monetary concerns.
LOS 19g: discuss absolute purchasing power parity and relative purchasing power parity, and calculate the end-of-period exchange rate implied by purchasing power parity, given the beginning-of-period exchange rate and the inflation rates.
absolute purchasing power parity (PPP): This is the idea of the law of one price. No matter what currency you are buying goods/svcs in, you end up paying one price. So the other currencies that you are purchasing in order to purchase goods/svcs denominated in those foreign currencies must depreciate/appreciate in order maintain the same net price level of whatever you are buying. This states that the weighted average price of all goods should equal the ratio of the average price levels and the exchange rate. In reality, this is not really possible. Price indexes such as the GDP Deflator (basket of produced goods) or some basket of consumed goods (CPI) is used in practice and is used to calculate inflation rates and price increases from one period to the next.
relative PPP: this links inflation to beginning-of-period and end-of-period exchange rates. Its a relationship that is generally accepted and looks like the formula below (FC = foreign currency, DC = domestic currency):
end of period exch rate/beg of period exch rate = (1 + FC inflation rate)/(1 + DC inflation rate)
This is used pretty much used in some form throughout all of these LOS. You are basically solving for some portion of this with the given information. In this case, you are given the beg period exch rate and the inflation rates and then solving for the end period exch rate.
Furthermore, the PPP relationship implies that returns and risks in other countries are equal when accounting for inflation. Because the inflation in one country is going to offset higher returns and vice-versa, an international portfolio manager will not care about exchange rate movements. In real-life, this doesn’t hold, especially in the short-run and is just a theory.
LOS 19h: discuss the international Fisher relation and calculate and interpret 1) interest rates exactly and by linear approximation, given expected inflation rates and the assumption that the international Fisher relation holds, 2) the real interest rate, given interest rates and inflation rates and the assumption that the international Fisher relation holds, and 3) the international Fisher relation, and its linear approximation, between interest rates and expected inflation rates.
The Int’l Fisher Relation states that the interest rate differential between two countries should be equal to the expected inflation rate differential over the term of the interest rate. Looking at this from just the domestic currency’s perspective, the home currency’s nominal interest rate is the compounding of the real interest rate and inflation. Like below:
(1 + r) = (1 + real r)(1 + exp infl rate)
or using the linear approx
r = real r + exp infl rate
This theory proposes that real interest rates are stable over time and therefore nominal interest rates (those including inflation) are due to changes/fluctuations in inflation rates and not real interest rates. From an international perspective, this theory implies that the ratio of the domestic and foreign nominal interest rates is equal to the ratio of expected inflation rates, like below:
(1 + rFC)/(1 + rDC) = (1 + FC infl rate)/(1 + DC infl rate)
or using the linear approx
rFC - rDC = FC infl rate - DC infl rate
In reality, this doesn’t really hold either but its closer. The Fisher Relation implies that real interest rates are the same, since the differences are accounted for in interest and inflation rates. This would only be true if all business cycles around the globe were synchronized and they are not. Countries that have different levels of economic growth should sustain different levels of interest rates. The basic idea of the Fisher Relation is that differences in real interest rates (nominal ex inflation) among countries would motivate capital flows between countries to take advantage of these real interest rate differentials. These capital flows would equalize the real interest rates across the world, in theory.
LOS 19i: discuss the theory of uncovered interest rate parity, explain the theory’s relationship to other exchange rate parity theories, and calculate and interpret the expected change in the exchange rate, given interest rates and the assumption that uncovered interest rate parity holds.
Uncovered interest rate parity refers to the idea that the exchange rate exposure is not covered or protected by a forward contract. While it looks a lot like covered interest rate parity, it is much different. Covered interest rate parity must hold by arbitrage, while uncovered interest rate parity is an economic theory whose empirical validity can be questioned. This parity relationship is a combination of the international Fisher relation and PPP.
Earlier in the text, it discussed interest rate parity. The formula was solving for the forward rate, and not the expected future exchange rate. The formula for Uncovered interest rate parity is below:
Exp Spot/current Spot = (1 + rFC)/(1 + rDC)
or the linear approximation
Exp % chg = rFC - rDC, then apply that amt to the exch rate you are solving for.
LOS 19j: discuss the foreign exchange expectation relation between the forward exchange rate and the expected spot exchange rate, and calculate and interpret the expected change in the exchange rate, given the forward exchange rate discount or premium, and discuss the implications of a foreign currency risk premium.
Because of the fact that someone can easily arbitrage the differences between the forward rate and the spot rate at the maturity of the forward contract, its assumed that there are no differences between the 2. This also implies that there is no reward for bearing forward exchange rate uncertainty. So calculating the differences in the forward rate and the future spot exchange rate is described in the formula below:
(F - Spot)/(Spot) = (Exp Spot - Spot)/(Spot) = Exp % chg = forward disc/premium
Given the forward exchange rate discount/premium, you would assume that it also equals the expected change in the exchange rate.
Implications of a foreign risk premium would mean that the risk premium would be paid by some and received by others (those bearing the risk). A zero-risk premium implies that using forward contracts to hedge is “costless” in terms of returns. It would also assume that its pointless since the forward rate will equal the future spot rate anyways.
LOS 19k: calculate the forward exchange rate, given the spot exchange rate and risk-free interest rates, using 1) interest rate parity, and 2) its linear approximation.
this is the same formula as before, except instead of the exp exch rate, its replaced by the forward exch rate.
Forward/Spot = (1 + rFC)/(1 + rDC) or
(Forward - Spot)/(Spot) = (rFC - rDC)/(1 + rDC)
and it’s linear approximation:
forward disc/premium = rFC - rDC
***Remember that Interest Rate Parity is an arbitrage relationship and not an economic theory like Uncovered Interest Rate Parity. Its simply financial arbitrage that must hold.
LOS 19l: discuss the implications of the parity relationships combined.
- Interest rate differentials reflect expectations about currency movements. In other words, the expected return on default-free bonds should be equal among countries. This is true whether we measure return in a common currency or in real terms.
- Investing in a country with a high interest rate is not a particularly attractive option. The high interest rate is expected to be offset by a matching currency depreciation.
- Investors from different countries expect the same real return on a given asset, once currency is taken into account.
- Exchange risk reduces to inflation uncertainty if all these relationships hold perfectly. In this instance, an investor concerned with real returns would not be affected by exchange rate uncertainty.
- Currency hedging allows investors to eliminate currency risk without sacrificing expected return, because the forward exchange rate is equal to the expected spot exchange rate.
LOS 19m: explain the roles of absolute purchasing power parity and relative purchasing power parity in exchange rate determination.
The long-run fundamental value of a currency is determined using PPP and assumed that deviations in the short-run will be corrected in the long-run. When using absolute PPP, a basket of goods that can be priced in different countries must be chosen, but the problem is that that is usually impossible. Using relative PPP, you must utilize several steps:
- select the inflation rate for each country
- select a historical period for which to compute long-run PPP
- determine the fundamental PPP value of the exchange rate, and hence, the current amount of over/undervaluation of the currency.
Using relative PPP helps explain future short-term movements in the exchange rate. Such estimation is not an easy task and usually results in using additional models for better understading of exchange rate movements.
LOS 19n: discuss the elements of balance of payments and their role in exchange rate determination.
There is a lot of information on the balance of accounts in the text, but I don’t think this LOS is asking for all of that (or at least I hope not). i feel like there have been 10 LOS on the balance of payments so I won’t go into great detail here because I feel like I’ve already gone over them. So, straight from the text:
“the elements in the balance of payments are the current account, the capital account, the financial account, and the official reserves account; without central bank intervention, a current account deficit must be balanced by a financial account surplus. Exchange rate adjustments can be needed to restore balance of payments equilibrium.”
There are a lot of issues in using the balance of payments to understand exchange rate movements. I may come back to this, but for now this is it.
LOS 19o: discuss the asset markets approach to pricing exchange rate expectations.
The idea here is that you have to determine what factors that affect exch rates are factors that can change quickly and factors that cannot. When there are sudden changes in inflation or money supplies, current interest rates are not going to change because intersest rates either change as a result of monetary police or as a result of growth within a country’s business cycle. So you assume that the currency is going to change to accomodate the PPP relationship in the long-run exch rate because prices generally are inelastic and change gradually over time. However, in the short-run, the current interest rate environment is going to price the expected long-run price relationship in and this is done by assuming that uncovered interest rate parity holds.
basically:
**an increase in expected inflation in a foreign country leads to a depreciation of the foreign currency
**a drop in real interest rates in a foreign country leads to a depreciation of the foreign currency.
LOS 19p: calculate the short-term and the long-run exchange rate effects of a sudden and unexpected increase in the money supply.
This is actually pretty straightforward. Its is based on determining the long-run expectations first and then backing into a currency based on short-run expectations.
1. Determine the long-run expected value of the exchange rate based on PPP, E(s). This is assumed to hold in the long-run.
end of period exch rate/beg of period exch rate = (1 + FC inflation rate)/(1 + DC inflation rate)
solving for end of period exch rate and assuming that is the long-run exch rate.
2. Infer the short-term value of the exchange rate, assuming that uncovered interest parity relation holds.
Exp Spot/current Spot = (1 + rFC)/(1 + rDC), plug the “end of period exch rate” into the “current Spot” and solve for “Exp Spot”.
The “Exp Spot” is the short-run, new exch rate.
geez, i’m so over this shit.
CFA: Foreign Exchange (18)
LOS 18a: define direct and indirect methods of foreign exchange quotations and convert direct (indirect) forex quotations into indirect (direct) forex quotations
direct quotations are generally quoting a foreign currency in terms of the local currency, which is expressing the local currency in terms of 1 unit of foreign currency. For example, EUR is usually quoted as $1.45, which is 1.45 $/EUR or $1.45 for 1 EUR.
indirect quotations is the exact opposite. So expressing EUR that is currently at $1.45 $/EUR would be about .68 EUR/$. this is done simply by taking the inverse (or pushing the “1/x” key on your calculator) of any number. Usually forex quotes are done using direct quotes from the American perspective, which is always in terms of the USD. However, there are exceptions such as the Yen which is always done as an indirect quote, 120 Yen/USD, for example.
again, you can go back and forth from direct to indirect by pushing the “1/x” button on your calculator.
LOS 18b: calculate and interpret the spread on a foreign currency quotation and explain how spreads on foreign currency quotations can differ as a result of market conditions, bank/dealer positions, and trading volume.
bid-ask quotes are something that I struggled with for a while. working for a trading desk helped remediate this but one way that I was able to keep them straight is to use a little nmemonic. bid = buy, so naturally ask = sell. but this isn’t the price for YOU to buy, this is the price that a bank is quoting on the market that they will buy the currency for. bids are always lower than asks, so “ask-bid = bid-ask spread”. keep in mind that traders on flow desks (where the desk is making markets and providing liquidity in whatever they are trading and not necessarily speculating on complex positions like say a hedge fund or prop desk would) are still trying to buy low and sell high, so the bid-ask quotes/spreads reflect that. its just like buying a car: you buy something and want to sell it right back to the dealer ship, they will only buy it back at a cheaper price than what they sold it to you, which is a crude example of the bid-ask spread.
so calculating the spread is done in terms of the ask: (ask price - bid price)/ask price. the midpoint is (ask + bid)/2. this should be obvious.
these spreads can differ for 3 major reasons (according to the CFA Institute): market conditions, bank/dealer positions, and trading volume. Market volatility will increase the size of bid-ask spreads because of bank/dealer risk aversion. The size of the spread does not depend on the bank/dealer positions, but rather the mid-point of that spread. Banks/Dealers advertising large spreads basically won’t trade and small spreads will cause them to lose money. When a bank has too much supply in a certain currency, it will make a favorable quote on the ask price or on the bid price, if it needed more supply. But the spread will remain the same. This will ensure that the bank/dealer can sell or buy what they need without filling additional orders in the wrong directions (buying when they should be selling, etc.). And the trading volume also affects spreads. This actually applies to just about anything as spreads are generally an indicator of liquidity. The less trading volume, the larger the spread, and vice-versa.
LOS 18c: calculate and interpret currency cross rates, given two spot exchange quotations involving three currencies.
calculating cross rates:
(FC1/FC2)ask = (FC1/DC)ask x (DC/FC2)ask
(FC1/FC2)bid = (FC1/DC)bid x (DC/FC2)bid
you could also flip everything around of course to get FC2/FC1. interpreting them is just like interpreting any other rate.
LOS 18d: distinguish between the spot and forward markets for foreign exchange
the spot markets are designed to accomodate settlements of commercial purchases of goods/svcs as well as investments - today. the forward markets are the same except that you as an investor enter into a contract and then commit to making the exchange at some point in the future at the exch rate set in the contract.
LOS 18e: calculate and interpret the spread on a forward foreign currency quotation and explain how spreads on forward foreign currency quotations can differ as a result of market conditions, bank/dealer positions, trading volume, and maturity/length of contract
spreads are done the same way as before: (ask-bid)/ask, when described as a %
forward contract spreads differ as a result of market conditions (volatility) and trading volume (more volume = lower spread), but not bank/dealer positions. Also, as maturity increases, so does the spread.
LOS 18f: calculate and interpret a forward discount or premium and express it as an annualized rate.
the forward premium/discount, which is the spread on the foreign currency, is calculated using the forumula below (and is annualized):
annualized forward premium/discount = (forward rate - spot rate)/(spot rate)(12/# mos on contract)x100%
LOS 18g: explain interest rate parity and illustrate covered interest arbitrage
Interest Rate Parity is the relationship between spot exchange rates, forward exchange rates, and interest rates (risk-free, gov’t).
covered interest arbitrage is where you taking advantage of this relationship in order to make a profit. This is done by borrowing domestic currency (DC) at the DC’s interest rate, converting it into a foreign currency (FC), and lending it at the FC’s interest rate and then buying a forward currency contract to lock in the forward exch rate used at expiration of both the lending/borrowing maturities to capture a riskless profit at expiration.
The forward rate must equal to the the spot times the respective DC’s interest rate to maturity (whatever that is) so that these types of interest rate arb strategies are not easily done - or not possible at all.
This LOS did not say calculate so I would expect a question asking what to do in a given situation where the differential is off and how to capture the riskless profit. Of course, in order to do that you need to be able to know the IR parity formula but that is explored in much more detail later on.
LOS 18h: calculate the profit on a triangular arbitrage opportunity, given the bid-ask quotations for the currencies of these countries involved in the arbitrage
The most confusing thing here is keeping the bid-ask quotes correct. The first thing to do is to find out first which currency is being sold cheaper in one location relative to another location. The text’s example doesn’t make sense because it assumes that you are buying at the bid and that doesn’t happen. I may be confusing this buy not sure. It is confusing to me a bit - I won’t lie.
The text states that bid is the rate that the dealer is willing to buy a currency for (or you selling it) and the ask is the rate that the dealer is willing to sell the currency for (or you buying it). the bid is always less than the ask. The example in Schweser doesn’t really help me either so I’ll have to come back to this.
LOS 18i: distinguish between spot and forward transactions, and calculate the annualized forward premium.discount for a given currency and infer whether the currency is “strong” or “weak”.
Spot transactions are transaction to exchange money today and forward transaction are to exchange money sometime in the future.
Forward premium/disc on exchange rate x/y for the currency y:
(forward rate - spot rate)/(spot rate) x (12/nbr mos going forward) x 100%
If the forward value is higher than its spot value, then the currency is strong and vice-versa to be weak.
CFA: International Finance (17)
LOS 17a: explain the different components of the balance of payments accounts, the transactions recorded for import and export on the different accounts, and how the three sector balances are related.
the three components are the current account, capital account, and the official settlements account.
the current account includes all international trading transactions, such as exports and imports of goods and services, net interest income paid abroad, and net transfers (foreign aid). this balance equals the sum of exports minus imports, net interest income (NII), and net transfers.
the capital account includes all foreign investment in the US minus US investment abroad. It also includes a statistical discrepancy that is not described much but is included as a line item in the list of type of transactions in the capital account. this also includes lending and borrowing but is defined as investment abroad and in the US by other foreign countries.
the official settlements account is basically a reserve balance that true’s-up the sum of the current account and the capital account to zero.
the current account is like a total amount of money spent and made through income while the capital account is like the amount of money the is borrowed in order to cover any money spent over the amount earned (current account deficit). the reverse of that would be a current account surplus and the capital account would be a net foreign investment in order to cover the amount of extra money made over the amount spent instead of net borrowing. the official settlements account is the account that is used to cover any shortfall between the difference in what is borrowed to cover any shortfalls in income vs expenditures. this account makes the sum of all three accounts equal to zero. there is usually very little change in this account over time and is usually much smaller than the balances on the other two accounts. typically, the sum of the balances on the other 2 accounts are supposed to be close to zero, so the shortfall covered with the official settlements account is usually proportionately much smaller.
the text goes into more detail here about determining if current account deficits are good or bad and how that is determined by how the borrowed money is used: to pay for growth or consumption? it doesn’t seem apparent that you need to go into these extra definitions because you have already answered the LOS with the information above
LOS 17b: explain the law of demand and the law of supply for foreign exchange, and how changes in demand and supply occur.
the law of demand for dollars or yen or yuan or rubles is all the same as the law of demand as it applies to any good or service in any market. if the price goes up, the demand decreases and if the price goes down, then the demand goes up. the text refers to the demand for dollars (assuming USD for the sake of this example, but could apply to any country’s currency) as a “derived” demand. People demand dollars so that they can buy US-made good and services, i.e.: US exports. People also demand dollars so that they can buy US assets such as bonds, stocks, businesses and real estate. this “derived” demand can be broken down into two categories: exports effect and expected profit effect.
exports effect: the larger the value of US exports, the larger is the quantity of dollars demanded on the foreign exchange (forex) market. the lower the exchange rate, with everything else constant, the cheaper US exports, thus the more the US exports and therefore the greater quantity of USD that is subsequently demanded in the forex market to pay for these increased exports.
expected profit effect: the larger the expected profit from holding USD, the greater is the quantity of USD demanded in the forex market. the lower the exch rate, everything held constant, the larger the expected profit from buying USD and the greater is the quantity of USD demanded in the forex market.
so as you can see, the law of demand is simple: the lower the exch rate, the greater the demand and vice-versa.
the primary drivers that change the demand of USD are interest rates in the US and other countries, and the expected future exch rate. these are the things that create shifts in the demand curve, while just changes in the exch rate causes movement along the curve.
for the first driver, interest rates, its not the level of rates in the US, but the relationship of the rates between the US and other countries. this is explained later, but this is the equilibrium referred to as the interest rate parity that exists between interest rates and exchange rates of 2 different countries or parities. this parity relationship can also be explained using US interest rate differentials. this is the gap or spread between interest rates in the US vs the interest rates in another country. the larger the difference, the greater the demand for US assets and thus the greater demand for dollars on the forex market.
again, on the second driver, the higher the expected exchange rate, the higher the demand for dollars. this is the same concept as the perception of cheap dollars today explained in the “expected profit effect”. if there are cheap dollars today, then there is an assumption of appreciation in the future. lower the price, the greater the subsequent demand. pretty straightforward.
the law of supply is also applied to USD as in anything else that can be bought or sold in a market or place of exchange. all else held constant, the higher the exchange rate the greater the quantity of USD supplied in the forex market. so if the exchange rate increases, the quantity of USD sold on the market also increases, adding to the existing supply in the market. again, this supply effect is very similar to the demand effect described earlier when I described “derived” demand. there are two reason why the supply is affected by the exch rate: imports effect and expected profit effect.
the imports effect states that the larger the value of US imports, the larger the quantity of foreign currency demanded to pay for these imports. this is exactly the same as the exports effect. when people buy foreign currencies, they are supplying dollars (i.e.: selling dollars to buy Yuan). whenever you are exchanging currencies, you are buying one and selling the other, so in order to buy imports, one has to sell USD in order to buy the foreign currency which enables you to buy the good from that foreign country. so the higher the exchange rate (the higher the price of the dollar), the cheaper are the foreign good and svcs to Americans and the greater the quantity of USD supplied in the forex market to pay for these imports (sell USD, buy Yuan to buy Chinese goods).
expected profit effect: the larger the expected profit from holding a foreign currency, the greater is the quantity of that currencey demanded and the greater is the quantity of the USD supplied in the forex market. so the higher the exch rate, the larger the expected profit from selling dollars (mantra: sell high, buy low) and the greater the quantity of USD supplied in the forex market.
again, the drivers that cause changes or shifts in the supply curve are the same as what causes shifts in the demand curve: interest rates in the US and other countries, and the expected future exch rate.
the larger the interest rate differential (or spread), the smaller is the demand for foreign assets and the smaller is the supply of USD on the forex market.
the higher the expected future exch rate, the smaller is the supply of dollars. basically, if you are expecting the asset (USD) to appreciate, then you won’t sell it until it has fully appreciated, thus reducing the supply of this asset in the marketplace. this applies to USD in the same way.
LOS 17c: discuss the influence of supply and demand on the exchange rate, and why exchange rates can be volatile.
if the demand for dollars increases while the supply remaining the same, the exch rate will increase. if the supply of dollars increases while the demand remaining the same, the exch rate will decrease. if the supply decreases at the same rate the demand increases, there is not change in the exch rate (theoretically of course).
volatility occurs because of the common influences (interest rates, future exch rate expectations) that supply and demand have on the exch rate. these common influences can quickly change the demand and the supply of dollars for or against the depreciation or appreciation of the local currency.
LOS 17d: distinguish between purchasing power and interest rate parity.
Purchasing Power Parity (PPP): this is where the exchange rates change in order to keep prices generally the same. the idea is that you can purchase goods and svcs for the same price after exchanging dollars for whatever. for example, when i buy records sometimes (yes vinyl records), i buy overseas at a distributor in England. Records are generally $10-12 USD when I buy them stateside, but when i buy them from England, I pay around 5-6 GBP. basically the records are the same price whether i’m buying them in the US or the UK. If records where to change prices in the US but not in the UK, then the exch rate would have to compensate for that difference. that is the idea behind PPP. if these prices rise quickly in the US but not in the UK, then the exch rate falls but if they rise in the UK and not in the US, then the exch rate rises.
Interest Rate Parity: this is where basically exchange rates change in order to maintain differentiations in interest rates between different countries. interest rates is the amount of return money can make you when lent out. so if there are different returns from different countries, then the exchange rate must compensate for those differences in order to make the overall return the same in either country. basically the higher the interest rate, the lower the exch rate. using the current price performance (exch rate performance) of the USD vs the EUR is a good example. in the last quarter of 2007, both countries were in divergent monetary policies, which means that we were cutting interest rates to promote growth and the ECB was raising interest rate&