Lesson:

Parities, Determination and

Exchange Rate Forecasts
PBL

What are the Pro’s and Con’s

of the MXN/USD at 22 vs 20?
Measuring Exchange Rate Movements

● An exchange rate measures the value of one currency in units of another

currency.

● When a currency declines in value, it is said to depreciate. When it increases in

value, it is said to appreciate.

● On the days when some currencies appreciate while others depreciate against
the dollar, the dollar is said to be “mixed in trading.”
Exchange Rate Equilibrium
An exchange rate represents the price of a currency, which is determined by the
demand for that currency relative to the supply for that currency
Factors that Influence Exchange Rates

● Relative Inflation Rates: Relatively high inflation discourages foreign

investment and encourages consumption abroad

● Relative Interest Rates: An increase attracts foreign investment for higher

returns, but a relatively high interest rate may actually reflect expectations
of relatively high inflation. It is thus useful to consider real interest rates,
which adjust the nominal interest rates for inflation. The “Fisher effect”

● Relative Income Levels: Higher income levels promotes more consumption

abroad
Factors that Influence Exchange Rates
● Government Controls: imposing foreign exchange barriers, imposing
foreign trade barriers, intervening in the foreign exchange market, and
affecting macro variables such as inflation, interest rates, and
income levels

● Expectations: Foreign exchange markets react to any news that may have
a future effect. Institutional investors often take currency positions based
on anticipated interest rate movements in various countries. Because of
speculative transactions, foreign exchange rates can be very volatile. Eg.
Fed minutes
Factors that Influence
Exchange Rates

Expectations. Signal Impact on USD

● Poor U.S. economic indicators: Weakened

● Fed chairman suggests Fed is unlikely to cut U.S. interest rates:
Strengthened
● A possible decline in German interest rates: Strengthened
● European Central bank expected to intervene to boost the euro: Weakened
● An increase in the level of income sometimes causes expectations of
higher interest rates
How Factors can affect Exchange Rates
How Factors can affect Exchange Rates

● Because the dollar’s value changes by different magnitudes relative to

each foreign currency, analysts often measure the dollar’s strength with an
index.

● The weight assigned to each currency is determined by its relative

importance in international trade and/or finance.

● Bloomberg Dollar Spot Index

Impact of Exchange Rates on an MNC’s
Value
Speculating on Anticipated Exchange Rates
Chicago Bank expects the exchange rate of the New Zealand dollar to
appreciate from its present level of $0.5 to $0.52 in 30 days.
Speculating on Anticipated Exchange Rates
Chicago Bank expects the exchange rate of the New Zealand dollar to
depreciate from its present level of $0.5 to $0.48 in 30 days.
International Arbitrage
● Arbitrage can be loosely defined as capitalizing on a discrepancy in quoted
prices. Often, the funds invested are not tied up and no risk is involved.
○ In response to the imbalance in demand and supply resulting from arbitrage activity,
prices will realign very quickly, such that no further risk-free profits can be made.
○ Any discrepancy will trigger arbitrage, which will then eliminate the discrepancy.
○ Arbitrage thus makes the foreign exchange market more orderly.

● Locational arbitrage is possible when a bank’s buying price (bid price) is

higher than another bank’s selling price (ask price) for the same currency.
○ It ensures that quoted exchange rates are similar across banks in different locations
International Arbitrage
● Triangular arbitrage is possible when a cross exchange rate quote differs
from the rate calculated from spot rates.
○ It ensures that cross exchange rates are set properly
○ When the exchange rates of the currencies are not in equilibrium, triangular arbitrage will
force them back into equilibrium
International Arbitrage

● Covered interest arbitrage is the process of capitalizing on the interest rate

differential between two countries, while covering for exchange rate risk.
○ It ensures that forward exchange rates are set properly

● Covered interest arbitrage tends to force a relationship between forward

rate premiums and interest rate differentials.

● Eg. If spot and forward rate are the same and interest rates between
countries aren’t.
Interest Rate Parity

● When IRP exists, the rate of return achieved from covered interest
arbitrage should equal the rate of return available in the home country.

● When IRP exists, it does not mean that both local and foreign investors will
earn the same returns.

● What it means is that investors cannot use covered interest arbitrage to

achieve higher returns than those achievable in their respective home
countries.
Does IRP Hold?

● Various empirical studies indicate that IRP generally holds.

● While there are deviations from IRP, they are often not large enough to
make covered interest arbitrage worthwhile.

● This is due to the characteristics of foreign investments, including

transaction costs, political risk, and differential tax laws.
IRP Considerations
IRP Considerations

Political Risk:
● A crisis in the foreign country could cause its government to restrict any
exchange of the local currency for other currencies.
● Investors may also perceive a higher default risk on foreign investments.
● Eg. Argentina imposes currency controls to support economy.
https://www.bbc.com/news/business-49547189

Differential Tax Laws:

● If tax laws vary, after-tax returns should be considered instead of before-
tax returns.
Impact of Arbitrage on an MNC’s Value
"A problem is a chance for you to
do your best" - Duke Ellington