Currency management - Reading 18

CFA Level III
#1

Let’s assume we have 2 currencies, A & B. Real interest rate in country A is higher than B so demand for currency A is higher (it attracts more foreign capital as per the curriculum), hence, currency A shall appreciate. But the Uncovered IR Parity says otherwise, if interest rate in country A is higher, currency A will depreciate … Can anyone help explain this?

Thanks,

#2

There are many forces that influence exchange rates.

Interest rate parity is one, supply and demand is another. They tend to work in opposite directions.

Nothing mysterious.

#3

Thank you @S2000magician, got it.

#4

Please correct me if this isnt technically correct, but this is how i understand it.

the total interest rate = real + interest/inflation.

In countries that have rapid inflation, the currency likely is depreciating. hence the money wont buy as much and it will depreciate There is no free lunch here. if the interest goes up, then most likely the buying power will adjust hence removing arbitage opportunity.

The exception to the rule if something happens to cause the real or intrinsic value of the currency to increase.

if that happens, then that would cause its value not to increase because of interest/inflation but because the currency is actually worth more from another influence. hence it grows in value.

hope this helps

#5

as far as I have seen from the curriculum, cfai always assume currencies are ‘sticky’ and the carry trade is always possible.

i.e. central banks do look at fx rates to ensure that the real economy (importers/exporters) are not hurt.

so covered/uncovered relationships are just needed to calculate profits.

#6

can you share with me where youre reading please

#7

Sure, its R18, 5. Currency management: tactical decisions.

#8

I think you’re right plus the curriculum also specifically mentions that “high-yield countries often see their currencies APPRECIATE, not depreciate, for extended periods of time …”

#9

My pleasure.

#10

I dont know if we’re allowed to quote but i noticed in learning outcome 19.d

point 1 is economic fundamentals (currency values will converge to fair value)

and point 3 (carry trade) says that it is a violation of uncovered interest rate parity.

Where is the quote about high yield currencies found?

I agree that there is currency volility …especially in the short term.

I wish to learn more about what is being discussed about “high yield countries”.

#11

1.REAL INTEREST rate in country A is higher than B so demand for currency A is higher…and it will appreciate…

  1. If INTEREST RATE(Not Real interest rate) in country A is higher, currency A will depreciate … The assumption is Real Interest rate should be same in the two countries(else money will flow to a country with higher Real interst rate) and difference in interest rate is due to inflation.The country with higher inflation,and hence higher (nominal) interest rate ,should see its currency depreciate.

3.Traders can Borrow in currecny with low interest rate(yield) and invest in “High Yielding Currencies” -both Nominal Rates-to take advantage of arbitrage whereupon interest differential and forward premium are not in agreement:

That is Interest Rate Parity ,as mandated by (1 + i$ )/(1 + iY ) = F/ S,approximated for small interest rate by, i$ − iY = (F − S)/ S ,IS VIOLATED,and taken advantage of.

Of course exchange rate is driven by demand and supply,but demand and supply is driven bymultiple factors,including Interest rates and ,trade.

#12

Good comment, somehow I missed this. Thanks.

#13

@crosstheevil,

My Pleasure.

#14

The disagreement can go either way: you may borrow the low-rate currency, or you may borrow the high rate currency. The important point is that you have a forward contract that guarantees your profit.

#15

^ I don’t think it’s that simple either. You have a better chance of capitalizing on lower realized inflation.

Inflation differentials should diverge exchange rates to keep the PPP, but this is mostly seen on the long run due to other factors influencing short term FX rates, kind of like how stock prices fluctuate around their fair value trend, but never really there at any point in time.

When it comes to real interest rates however, this is where supply and demand come into play. Higher real interest rate countries should not always see their currencies appreciate (although they do more often than not). The real key here is this, is the the real interest rate denominated in that foreign currency underpriced or overpriced? This is largely a shot in the dark, and used to play by speculators. Higher real interest rates in an efficent market should accuratley reflect higher soverign risk, and thus, currency exhange rates remain unaffected due to this variable. But currencies appreciate (or depreciate less) in general due to

  1. Lower expected inflation than implied by local (foreign) nominal interest rates

  2. Lower percieved risk than implied by local real interest rates

  3. Speculators jumping the techincal/momentum bandwagon, whereby short term appreciations coming from capital inflows in points (1) and (2) keeps driving the price higher unjustifiably, creating reflexive feedback loops

  4. The least common, currency attacks, as a result thereof

#16

Within the narrow context of the section I quoted, it is that simple: he was talking about arbitrage, which requires _ covered _ interest rate parity.

#17

There’s a 2 minute difference between both our posts.

#18

wink

#19

If I sell 1 USD at a 1-year fwd price @ 8.62 RMB/USD, the spot rate is 8 RMB/USD, and the interest rates are 10% and 2% resepectively. Then, I borrow 8 RMB and buy 1 USD.

A year later, the spot rate is 10 RMB/USD, I settle the fwd and recieve 8.62 RMB, convert the .02 USD to 0.2 RMB, and payback 8.8 RMB, that leaves me with a profit of 0.02 RMB.

So how do you profit from currency arbitrage? If the forward is at the arbitrage-free price, then your only exposure by buying/borrowing either currency is the future spot rate translating to a profit or a loss?

If the forward was above the AFP, then I would sell it, but how do I take arbitrage profit? Any rules to follow to make it easier to remember, gives me a headache trying to draw a flow chart in my head everytime this comes up.

#20

This is getting more fun :), in your example USD appreciates 25% against RMB in a year, this is more than enough to offset the rate differential (8%). Fwd price also does not converge to future spot price. IMO, this is not arbitrage free.