Currency Management

CFA Level III Portfolio Management
#1

McYelland is also examining various economic indicators to shape her market views. After studying the economic prospects for both Japan and New Zealand, she expects that the inflation rate for New Zealand is about to accelerate over the next few years, whereas the inflation rate for Japan should remain relatively stable.

Based on McYelland’s inflation forecasts, all else equal, she would be more likely to expect a(n):

  1. depreciation in the JPY/NZD.
  2. increase in capital flows from Japan to New Zealand.
  3. more accommodative monetary policy by the Reserve Bank of New Zealand.

Why the answer is A and not B since the increase in inflation would increase nominal interest rate and hence increase in capital flows to NZD.

Ref to above is given in the Economic forecast trading in currencies…

As a result, our model indicates that all else equal, the base currency’s real exchange rate should appreciate if there is an upward movement in

  • its long-run equilibrium real exchange rate;
  • either its real or nominal interest rates, which should attract foreign capital;
#2

Thanks for posting this question, I thought the same exact thing. I was going to post it but didn’t bother. Very confusing from everything else we learn. Would defintely love some insight into why it is A and not B, which would both make sense depending on the context.

Typically higher inflation means greater risk and also depreciation of currency per PPP; however, Increase inflation would make the central bank step in to control it and increase the rates, increasing rates = increased capital flows = greater demand for increased interest rate currency = appreciation in the short run.

#3

I try to provide my view here :

A is certain in the long-term perspective (if we assume PPP parity holds in the long-term) ;

B is not

Personal input : I do not invest my money ( I think large financial institutions tend to do the same) on a Fc currency which is expected to lose value because I will likely get less money when I convert it back to Dc => that would explain why large cash flows are not necessarily coming into the inflation-impacted system (i.e. NZD)

#4

Please let me knowIf I am wrong.

Higher inflation will lead to higher interest rate(r(NZD))

will go up ==> F(JPY/NZD)= S(JPY/NZD) ( 1+r(JPY))/(1+r(NZD)) will go down.

thus A, and in general relatively higher inflation will lead to depreation of that currency.

#5

Correct,

Forward exchange rate

F = S \frac {(1+i_f)} {(1+i_d)}

#6

If F is Currency A / Currency B and so is S

then F = S * (1 + i Currency A) / ( 1 = i Currency B)

#7

This assumes that F and S are quoted as f/d.

#8

I was also confused because we see so many ways in the curriculum to address currency management questions depending on whether the investor believes uncovered interest rate parity holds, purchasing power parity holds, and so on… I guess we have to be very careful about the assumptions that are made to set the context of the question.

I am not confident about anything in this chapter. I find it very difficult.

For example, when Rohit_sachan mentions “higher inflation will lead to higher interest rates”. Does it have to be like that? It depends if inflation was expected or not, right? Can’t nominal rates be rather stable on the short term and higher inflation lead to decreased real rates? In which case:

  • the forward rate resulting from the above formula will remain unchanged because it is based on nominal rate
  • But if we use the statement quoted by Hussain that “the base currency’s real exchange rate should appreciate if there is an upward movement in either its real […] rates, which should attract foreign capital” then this decrease in real rates should clearly lead to a depreciation of the NZD.

I hope I am not “complifying the simplicated side” here (quote S2000magician). I am so confused.

#9

I find the next question of the same example just as confusing. They conclude that we expect the Indian Rupee to appreciate if Indian autorities are tightening monetary policy, because real rates would increase. Wasn’t it the case in another chapter that we said that a currency would tend to depreciate in such a case, as such a policy would slow down the economy?