Through out this forum, I have seen many posters engage in pissing contests about which system, method, M.O, Way of trading....etc. The names for how we trade vary as much as the triggers we use to enter the markets. I however am still hungry after what will be my second year trading the markets for a more empirically based, more scientific approach to trading. This Thread will be for those who want to enter intelligent discussions on on the matter. This will not be a place to show your set ups....because "IF" you do I will expect solid, statistical, mathematical, falsifiable, replicable, and testable data with a well thought out rationale behind it.
I am not a guru and do not purport to be one, Cult mentality, superstitious and irrational thinking should only belong in RELIGION, not trading.
Before we get to statistics= charts
probabilities
risk models
and all the other good stuff myself and other traders want to jump to....I want to make sure that we understand the concept behind what we do everyday in the markets.
I am not claiming to teach you how to trade but I do want to dispel a lot of the B/S in this forum or corroborate that b/s with good rational thinking behind why certain things work.
to start of the thread here is a piece written by Showbik Karla from Harvard Business School, regarding exchange rate determinants.
http://people.hbs.edu/mdesai/IFM05/Kalra.pdf
December 13, 2005
SHOWBHIK KALRA
Note on Determinants of Foreign Exchange Rates
Exchange rates are relative prices of national currencies, and under a floating rate regime
they may be viewed as being determined by the interplay of supply and demand in
foreign exchange markets. The exchange rate simply expresses a national currency's
quotation in respect to foreign ones. For example, if one US dollar is worth 100 Japanese
yen, then the exchange rate of dollar is 100 yen. Therefore, the exchange rate is a
conversion factor, a multiplier or a ratio, depending on the direction of conversion. Thus,
the exchange rate can also be considered a price of one currency in terms of the other.
Exchange rate regimes (fixed or floating) are chosen by central banks (or governments).
It is important to distinguish nominal exchange rates from real exchange rates. Nominal
exchange rates are established on currency financial markets. Rates are usually
established in continuous quotation (they maybe fixed). Real exchange rates are nominal
rates corrected by inflation measures.
The next section presents some determinants of the nominal exchange rate. These
determinants could lead to changes of a floating exchange rate or put pressure on a fixed
exchange rate. The purpose of the note is not to determine how to forecast changes in
exchanges rates but is an attempt to discuss why exchange rates change.
Determinants of the Nominal Exchange Rate
1. Trade Balance
Exports, imports and the trade balance can influence the demand of currency aimed at
real transactions. An increasing trade surplus will increase the demand for country's
currency by foreigners (e.g. if the United States is running a trade surplus, there will be
demand from overseas for the USD to pay for these goods), so that there should be a
pressure for appreciation. A trade deficit should lead to the currency weakening.
If exports and imports largely determined by price competitiveness and the exchange rate
truly sensitive to trade imbalances, then any deficit would imply a depreciation followed
by booming exports and falling imports. Thus, the initial deficit would be quickly
reversed. Trade balances would almost always be zero.
But exports and imports are not only determined by price competitiveness (and the
exchange rate is not truly sensitive to trade imbalances), therefore trade imbalances can
be quite persistent (as is the case with the current trade deficit in the United States).
One reason is tariffs and quotas that exist to protect a country’s foreign exchange by reducing
demand. For e.g. till before liberalization, India followed a policy of tariffs and
restrictions on imports. Very few items were permitted to be freely imported.
Additionally, high customs duties were imposed to discourage imports and to protect the
domestic industry. Tariffs and quotas are not popular internationally as they tend to close
markets. Quotas are not restricted to developing countries. The United States imposes
quotas on readymade garments and Japan has quotas on certain non-Japanese goods.
Capital movements of foreign currency are usually connected with international trade.
When India began its economic liberalization and invited Foreign Institutional Investors
(FIIs) to purchase equity shares in Indian companies, billions of US dollars came into the
country strengthening the currency. In 1996 and 1997, due to the political situation, FIIs
took several billion US dollars (capital outflows) out of the country weakening the
currency.
2. Relative Purchasing Power Parity
Another form of real determination of exchange rate is offered by the "one price law" or
the “purchasing power parity”, according to which any freely good or service has the
same price worldwide, after taking into account nominal exchange rates. But in order to
equalize the price of several goods, more than one exchange rate may turn out to be
necessary, or an exchange rate that represents a tradable basket of goods and services.
The purchasing power parity exchange rate (PPP) between a foreign currency and the
U.S. dollar can be defined as:
PPP = (Cost of a Market Basket of Goods and Services at Foreign Prices) / (Cost of the Same Market Basket of Goods
and Services at U.S. Prices)
This gives us the exchange rate in terms of the units of foreign currency per dollar. The
dollars per unit of foreign currency is just the reciprocal.
The exchange rate between countries, therefore, should be such that the currencies have
equivalent purchasing power. For e.g. if a hamburger costs 3 US dollars in the United
States and 100 yen in Japan, then the exchange rate must be 100 yen per dollar. The
foreign exchange market would adjust, over the long term, to permit the functioning of
the "one price law", because the purchasing power of one currency increases (or
decreases) relative to another currency.
3. Relative Interest Rates
Interest rates on treasury bonds will influence the decision of foreigners to purchase
domestic currency in order to buy these treasury bonds. Higher interest rates will attract
capital from abroad, thereby increasing demand for the currency, and therefore the
currency will appreciate. Note, what is important is difference between domestic and
foreign interest rates, thus a reduction in foreign interest rates would have a similar effect.
Accordingly, an increase of domestic interest rates by the central bank could be
considered a way to defend the currency.
But, it may be the case that foreigners rather buy shares instead of treasury bonds. If this
were the strongest component of currency demand, then an increase of interest rate may
even lead to the opposite results, since an increase of interest rate quite often depresses
the stock market, leading to share sales by foreigners. A restrictive monetary policy
(increasing interest rates) usually also depresses the growth perspective of the economy.
If foreign direct investment are mainly attracted by future growth prospects and they
constitute a large component of capital flows, then this FDI inflow might stop and the
currency could weaken. Therefore, interest rates do have an important impact on
exchange rate but one has to be careful to check additional conditions.
Capital from abroad ↑; Demand for currency ↑;
Currency appreciates
Stock market ↓; Capital from abroad ↓;
Currency depreciates
Economic growth prospects ↓; FDI ↓; Currency
depreciates
Impact on the exchange rate when interest rates are raised
Interest Rates ↑
4. Relative Price Changes
The inflation rate is also considered to be a determinant of the exchange rate. A high
inflation rate should be accompanied by depreciation of the exchange rate. The more so if
other countries enjoy lower inflation rates, since it should be the difference between
domestic and foreign inflation rates to determine the direction and the scale of exchange
rate movements.
Therefore, if a hamburger costs 5% more in Japan than a year ago, while in USA it costs
8% more, then the dollar should have been depreciated this year by about 8%-5%=3%.
Here we have used the hamburger as a general example. The relationship between real,
nominal exchange rates and inflation can be expressed as the following approximation
(which can be applied to any two countries, not just the United States and Japan):
%ΔReal Exchange Rate (¥/$) ≈ %ΔNominal Exchange Rate (¥/$) – (Japanese Inflation % - U.S. Inflation %)
In reference to the overall price level of the economy, if exchange rates would move
exactly counterbalancing inflation dynamics, then real exchange rates should be constant.
5. Speculators, Traders and Financial Instruments
George Soros is most famous for his single-day gain of US$1 billion on Sept 6, 1992, which he
made by short selling the British pound. At the time, England was part of the European Exchange
Rate Mechanism, a fixed exchange-rate system which included other European countries. The
other countries were pressuring England to devalue its currency in relation to the other countries in
the system or to leave the system. England resisted the devaluation, but with continued pressure
from the fixed system and speculators in the currency market, England floated its currency and the
value of the pound suffered. By leveraging the value of his fund, Soros was able to take a $10
billion short position on the pound which made him US$1 billion. This trade is considered one of
the greatest trades of all time.
Past and expected values of the exchange rate itself may impact on current values of it.
The activities of foreign exchange traders, speculators and investors may turn out to be
extremely relevant to the determination of the market exchange rate. Financial
instruments like futures and forwards may also play an important role on the
determination of exchange rates.
A foreign exchange speculator who expects the spot rate of a foreign currency to be
higher in three months can purchase the currency in the spot market today at today's spot
rate, hold it for three months, and then resell it for the domestic currency in the spot
market after three months. If he is right, he will make a profit; otherwise, he will break
even or incur a loss. On the other hand, a foreign exchange speculator who expects the
spot rate of a foreign currency to be lower in three months can borrow the foreign
currency and exchange it for the national currency at today's spot rate. After three
months, if the spot rate on the foreign currency is sufficiently lower, he can earn a profit
by being able to repurchase the foreign currency (to repay the foreign exchange loan) at
the lower spot rate. (NOTE: To make a profit, the new spot rate must be sufficiently
lower to overcome the excess interest paid on the foreign currency borrowed for three
months, over the interest received on an equal amount of the national currency deposited
in a bank for three months.)
It is important to note that foreign exchange speculation usually takes place in the
forward market because it is simpler and, at the same time, involves no borrowing of the
foreign currency or tying up of the speculator's funds. Actions in foreign exchange
options markets can also influence exchange rates, especially in the short-term. To
understand the dynamics between spot rates, interest rates and forward rates it is
interesting to understand the mechanics behind covered interest arbitrage.
5.1. Covered Interest Arbitrage
Covered interest arbitrage is the transfer of liquid funds from one currency to another to
take advantage of higher rates of return or interest, while covering the transaction with a
forward currency hedge. Since the foreign currency is likely to be at a forward discount,
the investor loses on the foreign transfer currency transaction per se. But if the positive
interest differential in favor of the foreign money center exceeds the forward discount on
the foreign currency (when both are expressed in percentage per year), it pays to make
the foreign investment.
For e.g., when interest rates in the United States are greater than in Brazil (or elsewhere),
a Brazilian investor can exchange reals for dollars today and use these dollars to buy a 3-
month T-bill in New York at 12%. She earns 4% more per year (or 1% more per 3
months) than if he had used his reals to buy a 3-month T-bill in Brazil at 8%. If the spot
rate today is 3.0 real/$ and the spot rate in three months is 2.97 real/$, she will lose .03
reals or 1% on the foreign exchange conversion. The annualized 4% gain from the U.S.
T-bill is just offset by the annualized 4% currency loss. She breaks even.
If, on the other hand, the 3-month forward rate is between 3.0 and 2.97, the investor can
cover her foreign exchange rate risk by buying a forward contract to sell dollars in 3
months in exchange for reals. E.g. if the forward rate us 2.985:
Foreign currency loss = (3-month forward rate - spot rate)/spot rate
= (2.985 real - 3.0 real)/3.0real = -.015/3.0 = -0.5%
If the 3-month interest differential is 1% and the foreign exchange differential is only
0.5%, the investor nets 0.5% and should undertake the investment. This return (0.5%)
annualized is 2% per year. As long as the interest rate differential is greater than the
forward exchange rate differential, the Brazilian investor profits from buying U.S. T-bills
and selling forward dollars. In the process, she raises his return from 8% on the Brazilian
T-bill to 10.30% on the U.S. T-bill plus the foreign currency translation.
As funds are transferred from Brazil to the U.S., the supply of funds is reduced in Brazil
and increased in the US.
This tends to put upward pressure on interest rates in Brazil and
downward pressure on interest rates in the US, so that the positive interest differential of
4% per year will tend to fall toward 2% per year.
At the same time, the increased demand for dollars in the spot market tends to raise the
spot rate for dollars and the increased forward supply of dollars tends to push down the
forward rate. For both reasons, the forward discount on the dollar will tend to increase,
pushing it up to the interest rate differential.
Under normal conditions, the relationship between spot and forward rates is determined
largely by covered interest arbitrage (this relationship is known as the interest rate parity).
If interest rates are higher abroad, covered interest arbitrage tends to keep the foreign
currency at a forward discount (and the domestic currency at a forward premium) equal
to the positive interest differential in favor of the foreign monetary center. If domestic
interest rates are higher, covered interest arbitrage tends to keep the foreign currency at a
forward premium relative to the spot rate (and the domestic currency at a forward
discount) equal to the domestic positive interest differential. However, this may not hold
even approximately when covered interest arbitrage is forbidden or with large
destabilizing speculation taking place.
5.2. Interest Rate Parity
Interest rate parity is a relationship that must hold between the spot interest rates of two
currencies if there are to be no arbitrage opportunities. The relationship depends upon
spot and forward exchange rates between the currencies. It is:
• s is the spot exchange rate, expressed as the price in currency a of a unit of currency b
• f is the corresponding forward exchange rate
• ra and rb are the interest rates for the respective currencies
• m is the common maturity in years for the forward rate and the two interest rates.
The interest rate parity (covered interest arbitrage) plays a fundamental role in foreign
exchange markets, enforcing an essential link between short-term interest rates, spot
exchange rates and forward exchange rates.
5.3. Influence of the FX Options Market on Short-Term Exchange Expectations
Implied volatility is one of the key variables used to calculate the price of an FX option.
It is often interpreted as the market’s measure about possible future movements in spot
(related to the standard deviation of returns over a sample period). In the FX options
market, the preference of calls (right to buy a currency) over puts (right to sell a
currency) is measured by an asset class called risk reversal skew (RR) which is
mathematically defined as:
D delta Risk Reversal Skew = Implied Volatility of a D Delta Call – Implied Volatility of a D Delta Put
The FX market closely watches these risk
reversals. A positive RR, for example,
indicates preference for calls over puts, a
signal often perceived as bullish by the
market, leading to overbought positions in
the underlying currency, that further
exacerbate the RR. This is a par excellence
example of a self-fulfilling prophecy. A
defining example of this phenomenon was
the trend up in EUR from the lows in 2002
that saw the risk reversal continually
favoring EUR calls (see figure on left).
FX Option positions also give rise to a
phenomenon referred to as strike gravity. As the FX option trader deals in the spot market
to hedge a significant FX option position against a counterparty that is not an active
market participant, the spot gravitates towards the strike of the option as the trade
approaches maturity. This effect is more pronounced when the said position is an exotic
option with a digital payout and both the participants have access to liquidity in the cash
market to actively manage the exotic option. These FX flows arising from aggressive
hedging by the FX Option market players often dictate short-term currency moves.
6. Political and Psychological Factors
Political or psychological factors are also believed to have an influence on exchange
rates. Many currencies have a tradition of behaving in a particular way such as Swiss
francs which are known as a refuge or safe haven currency while the dollar moves (either
up or down) whenever there is a political crisis anywhere in the world. Exchange rates
can also fluctuate if there is a change in government. A few years back, India’s foreign
exchange rating was downgraded because of political instability and consequently, the
external value of the rupee fell. Wars and other external factors also affect the exchange
rate. For example, when Bill Clinton was impeached, the US dollar weakened. During the
Indo-Pak war the rupee weakened. After the 1999 coup in Pakistan (October/November
1999), the Pakistani rupee weakened.
sources
Historical chart of USD PKR exchange rate (01/01/1998 – 01/01/2002)
References
[1] Economics Web Institute (2001)
[2] Explaining Exchange Rate Behavior, Menzie D. Chinn, National Bureau of Economic
Research, Spring 2003
[3] The Determinants of Exchange Rate Movements, OECD, Economics and Statistics
Department, Graham Hoche, June 1983
[4] Macro for Managers, Harvard Business School, David Moss, January 2005
[5] Foreign Exchange Markets and Transactions, Harvard Business School Case, Mihir
Desai, October 2004
[6] Exchange Rate Policy at the Monetary Authority of Singapore, Harvard Business
School Case, Mihir Desai and Mark Veblen, January 2004
[7] Foreign Exchange Markets, San Jose State University, Economics Department,
Thayer Watkins
[8] Interviews with FX Options structuring group at Citigroup
Military coup in Pakistan
I hope with this thread to move past simple lines on a chart to make better sound, and intelligent decisions on our speculative activities.
I am not a guru and do not purport to be one, Cult mentality, superstitious and irrational thinking should only belong in RELIGION, not trading.
Before we get to statistics= charts
probabilities
risk models
and all the other good stuff myself and other traders want to jump to....I want to make sure that we understand the concept behind what we do everyday in the markets.
I am not claiming to teach you how to trade but I do want to dispel a lot of the B/S in this forum or corroborate that b/s with good rational thinking behind why certain things work.
to start of the thread here is a piece written by Showbik Karla from Harvard Business School, regarding exchange rate determinants.
http://people.hbs.edu/mdesai/IFM05/Kalra.pdf
December 13, 2005
SHOWBHIK KALRA
Note on Determinants of Foreign Exchange Rates
Exchange rates are relative prices of national currencies, and under a floating rate regime
they may be viewed as being determined by the interplay of supply and demand in
foreign exchange markets. The exchange rate simply expresses a national currency's
quotation in respect to foreign ones. For example, if one US dollar is worth 100 Japanese
yen, then the exchange rate of dollar is 100 yen. Therefore, the exchange rate is a
conversion factor, a multiplier or a ratio, depending on the direction of conversion. Thus,
the exchange rate can also be considered a price of one currency in terms of the other.
Exchange rate regimes (fixed or floating) are chosen by central banks (or governments).
It is important to distinguish nominal exchange rates from real exchange rates. Nominal
exchange rates are established on currency financial markets. Rates are usually
established in continuous quotation (they maybe fixed). Real exchange rates are nominal
rates corrected by inflation measures.
The next section presents some determinants of the nominal exchange rate. These
determinants could lead to changes of a floating exchange rate or put pressure on a fixed
exchange rate. The purpose of the note is not to determine how to forecast changes in
exchanges rates but is an attempt to discuss why exchange rates change.
Determinants of the Nominal Exchange Rate
1. Trade Balance
Exports, imports and the trade balance can influence the demand of currency aimed at
real transactions. An increasing trade surplus will increase the demand for country's
currency by foreigners (e.g. if the United States is running a trade surplus, there will be
demand from overseas for the USD to pay for these goods), so that there should be a
pressure for appreciation. A trade deficit should lead to the currency weakening.
If exports and imports largely determined by price competitiveness and the exchange rate
truly sensitive to trade imbalances, then any deficit would imply a depreciation followed
by booming exports and falling imports. Thus, the initial deficit would be quickly
reversed. Trade balances would almost always be zero.
But exports and imports are not only determined by price competitiveness (and the
exchange rate is not truly sensitive to trade imbalances), therefore trade imbalances can
be quite persistent (as is the case with the current trade deficit in the United States).
One reason is tariffs and quotas that exist to protect a country’s foreign exchange by reducing
demand. For e.g. till before liberalization, India followed a policy of tariffs and
restrictions on imports. Very few items were permitted to be freely imported.
Additionally, high customs duties were imposed to discourage imports and to protect the
domestic industry. Tariffs and quotas are not popular internationally as they tend to close
markets. Quotas are not restricted to developing countries. The United States imposes
quotas on readymade garments and Japan has quotas on certain non-Japanese goods.
Capital movements of foreign currency are usually connected with international trade.
When India began its economic liberalization and invited Foreign Institutional Investors
(FIIs) to purchase equity shares in Indian companies, billions of US dollars came into the
country strengthening the currency. In 1996 and 1997, due to the political situation, FIIs
took several billion US dollars (capital outflows) out of the country weakening the
currency.
2. Relative Purchasing Power Parity
Another form of real determination of exchange rate is offered by the "one price law" or
the “purchasing power parity”, according to which any freely good or service has the
same price worldwide, after taking into account nominal exchange rates. But in order to
equalize the price of several goods, more than one exchange rate may turn out to be
necessary, or an exchange rate that represents a tradable basket of goods and services.
The purchasing power parity exchange rate (PPP) between a foreign currency and the
U.S. dollar can be defined as:
PPP = (Cost of a Market Basket of Goods and Services at Foreign Prices) / (Cost of the Same Market Basket of Goods
and Services at U.S. Prices)
This gives us the exchange rate in terms of the units of foreign currency per dollar. The
dollars per unit of foreign currency is just the reciprocal.
The exchange rate between countries, therefore, should be such that the currencies have
equivalent purchasing power. For e.g. if a hamburger costs 3 US dollars in the United
States and 100 yen in Japan, then the exchange rate must be 100 yen per dollar. The
foreign exchange market would adjust, over the long term, to permit the functioning of
the "one price law", because the purchasing power of one currency increases (or
decreases) relative to another currency.
3. Relative Interest Rates
Interest rates on treasury bonds will influence the decision of foreigners to purchase
domestic currency in order to buy these treasury bonds. Higher interest rates will attract
capital from abroad, thereby increasing demand for the currency, and therefore the
currency will appreciate. Note, what is important is difference between domestic and
foreign interest rates, thus a reduction in foreign interest rates would have a similar effect.
Accordingly, an increase of domestic interest rates by the central bank could be
considered a way to defend the currency.
But, it may be the case that foreigners rather buy shares instead of treasury bonds. If this
were the strongest component of currency demand, then an increase of interest rate may
even lead to the opposite results, since an increase of interest rate quite often depresses
the stock market, leading to share sales by foreigners. A restrictive monetary policy
(increasing interest rates) usually also depresses the growth perspective of the economy.
If foreign direct investment are mainly attracted by future growth prospects and they
constitute a large component of capital flows, then this FDI inflow might stop and the
currency could weaken. Therefore, interest rates do have an important impact on
exchange rate but one has to be careful to check additional conditions.
Capital from abroad ↑; Demand for currency ↑;
Currency appreciates
Stock market ↓; Capital from abroad ↓;
Currency depreciates
Economic growth prospects ↓; FDI ↓; Currency
depreciates
Impact on the exchange rate when interest rates are raised
Interest Rates ↑
4. Relative Price Changes
The inflation rate is also considered to be a determinant of the exchange rate. A high
inflation rate should be accompanied by depreciation of the exchange rate. The more so if
other countries enjoy lower inflation rates, since it should be the difference between
domestic and foreign inflation rates to determine the direction and the scale of exchange
rate movements.
Therefore, if a hamburger costs 5% more in Japan than a year ago, while in USA it costs
8% more, then the dollar should have been depreciated this year by about 8%-5%=3%.
Here we have used the hamburger as a general example. The relationship between real,
nominal exchange rates and inflation can be expressed as the following approximation
(which can be applied to any two countries, not just the United States and Japan):
%ΔReal Exchange Rate (¥/$) ≈ %ΔNominal Exchange Rate (¥/$) – (Japanese Inflation % - U.S. Inflation %)
In reference to the overall price level of the economy, if exchange rates would move
exactly counterbalancing inflation dynamics, then real exchange rates should be constant.
5. Speculators, Traders and Financial Instruments
George Soros is most famous for his single-day gain of US$1 billion on Sept 6, 1992, which he
made by short selling the British pound. At the time, England was part of the European Exchange
Rate Mechanism, a fixed exchange-rate system which included other European countries. The
other countries were pressuring England to devalue its currency in relation to the other countries in
the system or to leave the system. England resisted the devaluation, but with continued pressure
from the fixed system and speculators in the currency market, England floated its currency and the
value of the pound suffered. By leveraging the value of his fund, Soros was able to take a $10
billion short position on the pound which made him US$1 billion. This trade is considered one of
the greatest trades of all time.
Past and expected values of the exchange rate itself may impact on current values of it.
The activities of foreign exchange traders, speculators and investors may turn out to be
extremely relevant to the determination of the market exchange rate. Financial
instruments like futures and forwards may also play an important role on the
determination of exchange rates.
A foreign exchange speculator who expects the spot rate of a foreign currency to be
higher in three months can purchase the currency in the spot market today at today's spot
rate, hold it for three months, and then resell it for the domestic currency in the spot
market after three months. If he is right, he will make a profit; otherwise, he will break
even or incur a loss. On the other hand, a foreign exchange speculator who expects the
spot rate of a foreign currency to be lower in three months can borrow the foreign
currency and exchange it for the national currency at today's spot rate. After three
months, if the spot rate on the foreign currency is sufficiently lower, he can earn a profit
by being able to repurchase the foreign currency (to repay the foreign exchange loan) at
the lower spot rate. (NOTE: To make a profit, the new spot rate must be sufficiently
lower to overcome the excess interest paid on the foreign currency borrowed for three
months, over the interest received on an equal amount of the national currency deposited
in a bank for three months.)
It is important to note that foreign exchange speculation usually takes place in the
forward market because it is simpler and, at the same time, involves no borrowing of the
foreign currency or tying up of the speculator's funds. Actions in foreign exchange
options markets can also influence exchange rates, especially in the short-term. To
understand the dynamics between spot rates, interest rates and forward rates it is
interesting to understand the mechanics behind covered interest arbitrage.
5.1. Covered Interest Arbitrage
Covered interest arbitrage is the transfer of liquid funds from one currency to another to
take advantage of higher rates of return or interest, while covering the transaction with a
forward currency hedge. Since the foreign currency is likely to be at a forward discount,
the investor loses on the foreign transfer currency transaction per se. But if the positive
interest differential in favor of the foreign money center exceeds the forward discount on
the foreign currency (when both are expressed in percentage per year), it pays to make
the foreign investment.
For e.g., when interest rates in the United States are greater than in Brazil (or elsewhere),
a Brazilian investor can exchange reals for dollars today and use these dollars to buy a 3-
month T-bill in New York at 12%. She earns 4% more per year (or 1% more per 3
months) than if he had used his reals to buy a 3-month T-bill in Brazil at 8%. If the spot
rate today is 3.0 real/$ and the spot rate in three months is 2.97 real/$, she will lose .03
reals or 1% on the foreign exchange conversion. The annualized 4% gain from the U.S.
T-bill is just offset by the annualized 4% currency loss. She breaks even.
If, on the other hand, the 3-month forward rate is between 3.0 and 2.97, the investor can
cover her foreign exchange rate risk by buying a forward contract to sell dollars in 3
months in exchange for reals. E.g. if the forward rate us 2.985:
Foreign currency loss = (3-month forward rate - spot rate)/spot rate
= (2.985 real - 3.0 real)/3.0real = -.015/3.0 = -0.5%
If the 3-month interest differential is 1% and the foreign exchange differential is only
0.5%, the investor nets 0.5% and should undertake the investment. This return (0.5%)
annualized is 2% per year. As long as the interest rate differential is greater than the
forward exchange rate differential, the Brazilian investor profits from buying U.S. T-bills
and selling forward dollars. In the process, she raises his return from 8% on the Brazilian
T-bill to 10.30% on the U.S. T-bill plus the foreign currency translation.
As funds are transferred from Brazil to the U.S., the supply of funds is reduced in Brazil
and increased in the US.
This tends to put upward pressure on interest rates in Brazil and
downward pressure on interest rates in the US, so that the positive interest differential of
4% per year will tend to fall toward 2% per year.
At the same time, the increased demand for dollars in the spot market tends to raise the
spot rate for dollars and the increased forward supply of dollars tends to push down the
forward rate. For both reasons, the forward discount on the dollar will tend to increase,
pushing it up to the interest rate differential.
Under normal conditions, the relationship between spot and forward rates is determined
largely by covered interest arbitrage (this relationship is known as the interest rate parity).
If interest rates are higher abroad, covered interest arbitrage tends to keep the foreign
currency at a forward discount (and the domestic currency at a forward premium) equal
to the positive interest differential in favor of the foreign monetary center. If domestic
interest rates are higher, covered interest arbitrage tends to keep the foreign currency at a
forward premium relative to the spot rate (and the domestic currency at a forward
discount) equal to the domestic positive interest differential. However, this may not hold
even approximately when covered interest arbitrage is forbidden or with large
destabilizing speculation taking place.
5.2. Interest Rate Parity
Interest rate parity is a relationship that must hold between the spot interest rates of two
currencies if there are to be no arbitrage opportunities. The relationship depends upon
spot and forward exchange rates between the currencies. It is:
• s is the spot exchange rate, expressed as the price in currency a of a unit of currency b
• f is the corresponding forward exchange rate
• ra and rb are the interest rates for the respective currencies
• m is the common maturity in years for the forward rate and the two interest rates.
The interest rate parity (covered interest arbitrage) plays a fundamental role in foreign
exchange markets, enforcing an essential link between short-term interest rates, spot
exchange rates and forward exchange rates.
5.3. Influence of the FX Options Market on Short-Term Exchange Expectations
Implied volatility is one of the key variables used to calculate the price of an FX option.
It is often interpreted as the market’s measure about possible future movements in spot
(related to the standard deviation of returns over a sample period). In the FX options
market, the preference of calls (right to buy a currency) over puts (right to sell a
currency) is measured by an asset class called risk reversal skew (RR) which is
mathematically defined as:
D delta Risk Reversal Skew = Implied Volatility of a D Delta Call – Implied Volatility of a D Delta Put
The FX market closely watches these risk
reversals. A positive RR, for example,
indicates preference for calls over puts, a
signal often perceived as bullish by the
market, leading to overbought positions in
the underlying currency, that further
exacerbate the RR. This is a par excellence
example of a self-fulfilling prophecy. A
defining example of this phenomenon was
the trend up in EUR from the lows in 2002
that saw the risk reversal continually
favoring EUR calls (see figure on left).
FX Option positions also give rise to a
phenomenon referred to as strike gravity. As the FX option trader deals in the spot market
to hedge a significant FX option position against a counterparty that is not an active
market participant, the spot gravitates towards the strike of the option as the trade
approaches maturity. This effect is more pronounced when the said position is an exotic
option with a digital payout and both the participants have access to liquidity in the cash
market to actively manage the exotic option. These FX flows arising from aggressive
hedging by the FX Option market players often dictate short-term currency moves.
6. Political and Psychological Factors
Political or psychological factors are also believed to have an influence on exchange
rates. Many currencies have a tradition of behaving in a particular way such as Swiss
francs which are known as a refuge or safe haven currency while the dollar moves (either
up or down) whenever there is a political crisis anywhere in the world. Exchange rates
can also fluctuate if there is a change in government. A few years back, India’s foreign
exchange rating was downgraded because of political instability and consequently, the
external value of the rupee fell. Wars and other external factors also affect the exchange
rate. For example, when Bill Clinton was impeached, the US dollar weakened. During the
Indo-Pak war the rupee weakened. After the 1999 coup in Pakistan (October/November
1999), the Pakistani rupee weakened.
sources
Historical chart of USD PKR exchange rate (01/01/1998 – 01/01/2002)
References
[1] Economics Web Institute (2001)
[2] Explaining Exchange Rate Behavior, Menzie D. Chinn, National Bureau of Economic
Research, Spring 2003
[3] The Determinants of Exchange Rate Movements, OECD, Economics and Statistics
Department, Graham Hoche, June 1983
[4] Macro for Managers, Harvard Business School, David Moss, January 2005
[5] Foreign Exchange Markets and Transactions, Harvard Business School Case, Mihir
Desai, October 2004
[6] Exchange Rate Policy at the Monetary Authority of Singapore, Harvard Business
School Case, Mihir Desai and Mark Veblen, January 2004
[7] Foreign Exchange Markets, San Jose State University, Economics Department,
Thayer Watkins
[8] Interviews with FX Options structuring group at Citigroup
Military coup in Pakistan
I hope with this thread to move past simple lines on a chart to make better sound, and intelligent decisions on our speculative activities.
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