Exchange Rates Forecasting

There are three principal ways in which trade goods and services can influence exchange rates:

• Trade flows.
• Purchasing power parity.
• Current account.

Trade flows tend to make up a small portion of total GDP and exert little influence on exchange rates. The increasing influence of trade flows on exchange rates could signify an ongoing crisis.

Purchasing Power Parity

Purchasing power parity (PPP) is the idea that prices of goods and services in two countries should align after considering the conversion of currencies.

Purchasing power parity is much more accurate in the long run. In the short term, it is theoretical and does not always show up perfectly in practice. The mechanism upon which it functions is like the idea of arbitrage: consumers could buy lower-priced items and sell the same items at a higher price later. This lacks a true arbitrage’s instantaneous nature but follows the same logic.

Capital Mobility

Capital seeks the highest risk-adjusted return. This means that countries that offer better risk-adjusted returns should see capital inflows. The following formula encompasses the expected rate of change of a foreign currency denominated in local currency:

$$ \begin{align*} E \left( \% \Delta S_{\left( \frac {d}{f} \right)} \right) & = (r^d – r^f) + (\text{Term}^d – \text{Term}^f) + (\text{Credit}^d – \text{Credit}^f) \\ & + (\text{Equity}^d – \text{Equity}^f) + (\text{Liquid}^d – \text{Liquid}^f) \end{align*} $$

Where:

\(E \left( \% \Delta S_{\left( \frac {d}{f} \right)} \right)\) is the expected change in the exchange rate of domestic and foreign currency.

\(r^d – r^f\) is the nominal interest rate differential of domestic and foreign markets.

\((\text{Term}^d – \text{Term}^f)\) is the term premium differential.

\((\text{Credit}^d – \text{Credit}^f)\) is the credit premium differential.

\((\text{Equity}^d – \text{Equity}^f)\) is the equity premium differential.

\((\text{Liquid}^d – \text{Liquid}^f)\) is the liquidity premium differential.

The above equation states that exchange rates are not only a function of short-term nominal interest rates but also of term, credit, equity, and liquidity premiums, with the domestic variable having a positive relationship with the expected change in currency and the foreign variable having a negative relationship.

Uncovered Interest Rate Parity

Uncovered interest rate parity (UIP) suggests that the expected percentage change in the exchange rate should equal the nominal interest rate differential. That is, only the first term in the prior equation matters. Again, this is often more theoretical than reality.

Carry Trades

A carry trade is a trading strategy that involves borrowing at a low interest rate and investing in an asset that provides a higher rate of return. A carry trade is typically based on borrowing in a low-interest-rate currency and converting the borrowed amount into another currency. It is widely accepted that carry trades earn meaningful profits under most market conditions, which conflicts with the uncovered interest rate parity.

Question

Which of the following descriptions of could most likely be a carry trade?

1. Borrow in an emerging economy and invest in a developed economy.
2. Borrow in a developed economy and invest in an emerging economy.
3. Borrow in a high-interest rate environment and invest in a low-rate environment.

Solution

The correct answer is B.

Borrow in a developed economy and invest in an emerging economy. A carry trade is a trading strategy that involves borrowing at a low interest rate and investing in an asset that provides a higher rate of return. Typically, this involves borrowing in a low-interest-rate currency and converting the borrowed amount into another currency. Developed economies often have lower interest rates than emerging economies, so borrowing in a developed economy and investing in an emerging economy could be an example of a carry trade. This strategy allows the investor to exploit the interest rate differential between the two economies. However, it’s important to note that carry trades can be risky and are best suited for sophisticated investors with a high tolerance for risk.

A is incorrect. It does not take into account the interest rates of the two economies. Emerging economies often have higher interest rates than developed economies, so borrowing in an emerging economy would likely result in paying a higher interest rate on borrowed funds. This would not be an effective carry trade strategy, as the goal is to borrow at a low interest rate and invest in an asset that provides a higher rate of return.

C is incorrect. It describes borrowing in a high-interest rate environment and investing in a low-rate environment, which is the opposite of what a carry trade aims to do. In a carry trade, you want to borrow at a low-interest rate and invest in an asset that provides a higher rate of return.

Asset Allocation: Learning Module 2: Capital Market Expectations – Part 2 Forecasting Asset Class Returns; Los 2(f) Discuss major approaches to forecasting exchange rates