- [FX forecasting using Purchase Power Parity] Expected inflation rates now until the end of 2008 are 3.5% in the U.S., and 12% in Argentina, respectively. The current spot exchange rate between Argentina peso (AP) and the U.S. dollar is AP3.18/$. What will be the expected exchange rate between Argentina peso (AP) and the U.S. dollar in the indirect quotation (i.e., AP/$) at the end of 2008? Explain why.
The Fisher Effect:
Interest rates change for two reasons:
- the real interest rate changes;
- or, the inflation rate changes (Mishkin & Eakins 336)
ef = Exp (S ↓t + 1) – S ↓ t ÷ S ↓ t International Fisher Effect (Mallet 11)
ef = If – Ih (Inflation for foreign country – Inflation for home country) or percent of
change in foreign currency value (Mallet 11)
S = Spot Rate
t = time
8.5%= Exp(3.18*.5+1) – 3.18*.5/3.18*.5=4.77-3.18*.31=4.77-.99=3.78
Argentina has a higher inflation rate than the U.S. The inflation rate of the Argentina Peso will depreciate the U.S. dollar. It will cause the U.S. to be less competitive abroad and make inflation rise in the U.S. due to the “decline in the value of the dollar” (Mishkin and Eakin 193). Extreme movements within the value of any currency pose serious threats to the economical and social conditions of the country (Mishkin and Eakin 193). When foreign interest rates rise our exchange rate declines. To summarize, the case of Argentina above, the domestic interest rates will rise due to the increase in inflation and the U.S. dollar will depreciate.
- [Euro and the U.S. dollar] Using your own source of information, please find out:
i). What is the spot exchange rate between the Euro and the U.S. dollar in terms of the
May 21, 2008
EURUSD 1.5785 -0.13% (Easy Forex Trading Platform www.easy-forex.com/EN/Forex.Outlook.aspx)
ii). The interest rate for 6-month Treasury Bill (TB) in the U.S. is 3% (annual rate), while the interest rate for equivalent investment in the Euro nations is 6%. What do you expect for 6-month forward rate for $/Euro? [use the spot rate of $/Euro from your answer for Q i) to forecast the 6-month forward rate.] forward rate = (1 + .06/2*.5)/1+.03/2*.5= 1.02 /1.01= 1.01
iii). Please compare your answer for Q ii) and the 6-month foreign exchange futures rate for $/Euro. Please discuss the relationship between the two rates.
The forward rate is lower. The futures pays more up front that can be reinvested and money earned back before you will earn on the forward account. You have to wait longer on the forward account to earn money back. You can also do a hedge and lock in the higher earning interest rate which will secure more earning in the futures contract, which stating again as you bring in interest income you can capitalize on the earnings by reinvesting. You cannot do the same as quickly with a forward contract.
- [Chinese Renminbi Yuan] The U.S. had current account deficit of $740 billion during 2007. By country, the U.S. had the largest trade deficit against China, as large as $220 billion. There have been two very different views on the role of the exchange rate between Chinese Yuan and the U.S. dollar. Please discuss which view you support and offer your own opinion on this issue.
View #1: Some U.S. politicians want to pressure China to increase the value of the Chinese Yuan, which is pegged to the currency basket consisting major currencies including the U.S. dollar. They claim that the Yuan has been the cause of the large U.S. trade deficit with China. Some critics argue that China has been using the exchange rate as a form of trade protectionism. That is, China has discouraged imports and encourages exports by keeping the value of its currency artificially low. It is not fair. The Yuan has appreciated to around 7 Yuan per dollar from 8.27 since 2 years ago, but the appreciation is not enough and too slow.
I would agree to this viewpoint. It is advantageous for China to keep the value of the Yuan lower. When the foreign exchange rate drops for the domestic interest rates in a country; the domestic interest exchange rates are increased; import demand is lower and export demand is increased (Mishkin & Eakins, 193). Thus, when a country is controlling the price of its currency this way it is a form of trade protectionism. It also enables the country to rack up on high manufacturing profits through the exporting and production industries and poses to potentially cause other countries huge indebtedness because the corporations in other countries are taking advantage of the lower price of the currency in manufacturing in China. In essence, the government in China is undercutting the laborers in other countries by lowering their currency to lure manufacturing industries to their country and becoming an economic superpower.
View #2: The US trade deficit is mainly due to the problems in the US economy and business. For example, the US trade deficit can be partially attributed to the very high prices in the US, which are necessary to cover the excessive compensation for executives and other employees at the US firms. (WSJ reported recently that average compensation packages for CEOs of the Wall Street investment banking firms were 20-30 million in 2007.) The high prices in the US encourage firms and consumers to purchase goods from China. It helps the US consumers. Even if China’s Yuan is revalued upward, this does not necessary mean that the US firms and consumers will buy US products. They may simply shift their purchases from China to the products in Indonesia or low-wage countries. Thus, the underlying dilemma is not China, but any country that has lower costs of production than the US.
Eakins,S. & Mishkin, F. (2006). Financial markets and institutions, 5th Edition. Boston: Pearson,
ActionForex.com (2008). Market Overview. ActionForex.com (2008). © 2008 All rights
Reserved. On the Internet at: www.actionforex.com/
ActionForex.com (2008). Purchasing Power Parity. ActionForex.com © 2008 All rights reserved On the Internet at:
Easy Forex Trading Platform (2008). May 21,2008. On the Internet at:
Foreign Exchange Outlook Rates Trends and Currency Shifts
Mallet, Jim. (2007). Relationships between inflation , interest rates, and exchange rates. FIN
503 Powerpoint Presentation, ppts. 1-23. On the Internet at:
nt times during the day in the various business hours.