Central bank policy rate hike (effect on currency)

CFA Level III Portfolio Management
#1

CFAI Example 8 Q 2.

The Reserve Bank of New Zealand (RBNZ) is New Zealand’s central bank, and is scheduled to announce its policy rate decision within the week. The consensus forecast among economists is that the RBNZ will leave rates unchanged, but Bhattathiri believes that the RBNZ will surprise the markets with a rate hike.

  1. Given her market view, Bhattathiri would most likely choose which of the following long positions?
  2. 5-delta put option on NZD/AUD
  3. 10-delta put option on USD/NZD
  4. Put spread on JPY/NZD using 10-delta and 25-delta options

I though that NZD would depreciate and hence picked B

However the answer says A because of this.

A is correct. The surprise rate hike should cause the NZD to appreciate against most currencies.

Why would surprice rate hike cause NZD to appreciate?

#2

The big idea is that higher interest rates will attract more foreign capital which increases demand for the currency thereby driving the value higher.

#3

^ Depends on what section of the book we’re looking at.

If there is no carry trade assumed, then it the NZD would depreciate according to CIRP

If carry trade assumed, then NZD would appreciate

#4

I get really confused with the P/B format when it comes to options. If its going to appreciate, would that put allow you to sell NZD buy AUD, which would be counter intuititve. Wouldn’t a call option on NZD/AUD be more appropriate if you think the currency will appreciate?

#5

Reading 19 Example 8.

Just checked one of the past exam and you won’t be told which section of the book it will be.

So without that knowledge we need to answer this…

#6

But according to interest rate parity, the currency should depreciate.

#7

My confusion is only in this part.

Why would higher policy rate surprice currency to be appreciated?

Is it because its a _ surprise _ opposite to investor’s expectation and hence investors would flee to the market causing higher demands and hence appriation?

If it was not a surprise, it would be depreciation according to interest rate parity?

Magician, CPK, tozerrt, anyoune?

#8

there are two conflicting things

If a country increases interest rates, the currency will appreciate. Because, it will attract flows for a higher yield.

However, a currency that has a higher interest rate trades at a forward discount ( IRP ). This should cause the currency to depreciate over a longer term.

Just think of this way - in the near term, higher interest rate will cause currency to appreciate. Over a longer term, the effect will be determined by other things too, as IRP does not always hold.

As for the answer - a put option on NZD/AUD means a put option on AUD , which is a call option on NZD. Try to link currency questions with the base currency.

PS - The CFAI for a strange reason mentions the currency quotes as P/B, whereas in practical life it is B/P. Don’t mix real life and CFAI.