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## Forecasting Exchange Rate

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**The Zimbabwe government redenominated the ZWD again on**February 2, 2009 at a rate of 1,000,000,000,000 old ZWD to 1 new ZWD. Forecasting Exchange Rate**International Parity Condition**Chapter 4 Eiteman, Stonehill, and Moffet**Forecast change in spot exchange rate**+4% (yen strengthens) Purchasing Power Parity (A) Forward rate as an unbiased predictor (E) Forward premium on foreign currency +4% (yen strengthens) Forecast difference in rates of inflation -4% (less in Japan International Fisher Effect (C ) Interest Rate Parity (D) Difference in nominal interest rates -4% (less in Japan) Fischer Effect (B)**Purchasing Power Parity (Absolute)**If the identical product or service can be sold in two different markets, and no restrictions exist on the sale or transportation costs of moving the product between markets, the product’s price should be the same in both markets.This is called the law of one price If the two markets are two different countries, the product’s price may be stated in different currency terms, but the price of the product should be still the same**Actual USD/GBP and PPP Exchange Rates**Actual Rate PPP Rate**Actual DEM/USD and PPP Exchange Rates**Actual Rate PPP Rate**Actual JPY/USD and PPP Exchange Rates**Actual Rate PPP Rate**Actual CAD/USD and PPP Exchange Rates**PPP Rate Actual Rate**Actual MXN/USD and PPP Exchange Rates**Actual Rate PPP Rate**Evidence on PPP**• PPP probably doesn’t hold precisely in the real world for a variety of reasons. • Haircuts cost 10 times as much in the developed world as in the developing world. (Transaction Costs) • Sticky Prices (Exchange Rate Pass Through) and Non Competitive Markets • Shipping costs, as well as tariffs and quotas can lead to deviations from PPP. • Can We Make Profit from It ? • PPP-determined exchange rates still provide a valuable benchmark. • PPP holds up well over the very long run but poorly for shorter time periods • The theory holds better for countries with relatively high rates of inflation and underdeveloped capital markets**Relative Purchasing Power Parity**Thespot exchange rate should change in an amount equal to but in the opposite direction of the difference in inflation rate between two countries I$ - I¥ Beginning Rate – Ending Rate X 100 = Ending Rate 1 + I¥**Contoh Soal**• Misalkan tingkat inflasi di Denmark pada tahun 2009 adalah 1.30%, sedangkan tingkat inflasi di India adalah 14.97%. Saat ini kurs yang berlaku adalah Rupee 8.3972/Kroner. Jika relative purchasing power parity berlaku, maka berapa perkiraan kurs tukar tersebut satu tahun mendatang ?**The Fisher Effect**The Fisher Effect states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation i = r + + r Where i is the nominal rate of interest, r is the real rate of interest, and is the expected rate of inflation over the period of time for which funds are to be lent. The final compound term, r, is frequently dropped from consideration due to its relatively minor value**International Fischer Effect**Thespot exchange rate should change in an amount equal to but in the opposite direction of the difference in interest rate between two countries i$ - i¥ Beginning Rate – Ending Rate X 100 = Ending Rate 1 + i¥**International Fischer Effect**• Assume that one year interest rates are 3% in US and 5% in the Euro zone. The spot rate between the Euro and the dollar is €1.02/$. Assuming International Fisher Effect holds, what should the €/$ rate be one year hence ?**International Fischer Effect**Dengan demikian, perkiraan rate untuk satu tahun kedepan adalah Euro 1.0398/$ (jika memenuhi kondisi International Fischer Effect) 1.02 - X 3% - 5% = X 1 + 5% 1.071 – 1.05 X = -0.02X 1.03 X = 1.071 X = 1.0398**Interest Rate Parity**The difference in the national interest rates for securities of similar risk and maturityshould be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction costs**Covered Interest Arbitrage**The spot and forward exchange markets are not, however, constantly, in the state of equilibrium. When the market is not in equilibrium, the potential for “riskless” or arbitrage profit exists. This is called covered interest arbitrage**Soal Covered Interest Arbitrage**• James Chang, a foreign exchange trader at JP Morgan Chase, can invest $ 5 million or the foreign currency equivalent of the bank’s short term fund in a covered interest arbitrage with Denmark. He has the following quotes • Can James Chang make a covered interest arbitrage profit ?**Soal Covered Interest Arbitrage**• Assume that interest rates in the US increase to 4% per year (1% for 90 days) but all other rates remain the same. Can James Chang make a 90 day covered interest arbitrage profit ? • Assume that interest rates in the Euro zone increase to 6% per year (1.5% for 90 days), but all other rates remain the same, including the original US interest rate of 3% per year. Calculate whether James Chang could make a 90-day covered interest arbitrage profit ?**Uncovered Interest Arbitrage**• Investors borrow in countries and currencies exhibiting relatively low interest rates and convert the proceeds into currencies that offer much higher interest rates. • The transaction is “uncovered” because the investor does not sell the higher yielding currency proceeds forward, choosing to remain uncovered**Carrytrade**Istilah carry trade, umumnya, mengacu pada strategi carry trade dalam perdagangan mata uang. Tak perlu pusing, sejatinya, ini adalah strategi yang sederhana saja. Dalam carry trade, investor meminjam uang dari negara berbunga rendah dan membiakkannya di negara lain yang masih memasang bunga tinggi. Jadi, ini mirip dengan strategi "beli di harga rendah dan jual di harga tinggi".Praktik yang paling sering terjadi, investor meminjam dana dari perbankan Jepang dan kemudian membiakkan dana itu di negara-negara lainnya seperti Australia, Selandia Baru, Amerika, dan juga Indonesia. Maklum, saat ini bunga di Jepang adalah yang paling rendah, hanya 0,5%. Ambil contoh, misalnya, seorang investor, meminjam dana di Jepang sebesar 1.000 yen, mengonversinya menjadi rupiah, dan menginvestasikan di Indonesia. Dengan kurs Rp 73,9 per yen, artinya dalam rupiah dana itu setara dengan Rp 73.900. Nah, cukup dengan menginvestasikan dana itu di Sertitikat Bank Indonesia (SBI) yang berbunga 8,25%, investor itu sudah akan langsung menikmati keuntungan bunga 7,75%. Jika ia menginvestasikan dana ini di saham atau obligasi, tentu, keuntungannya bisa berlipat-lipat.**Icelandic Mess**Uttlesford is just one of dozens of local authorities in Britain that have parked money, nearly $1.5 billion in total, in Icelandic bank accounts, which were aggressively promoted in this country as high-yielding, but safe, investments. Well-known charities, nonprofit groups and institutions such as Oxford University and a cancer hospital in northern England put their funds in Icelandic banks. So did millions of individual Britons, who opened their accounts over the Internet and happily watched their balances grow, at least online. The British government’s own watchdog agency for public spending confessed to having $16 million tied up in Iceland, whose banking industry was so heavily leveraged that some called the country one giant Viking hedge fund. When those banks started sinking with stunning swiftness around the beginning of October, Reykjavik was forced to intervene and, essentially, nationalize Iceland’s largest financial institutions. Investors here in Britain panicked as their money was now frozen by the Icelandic government as it tried to sort out the banking mess. The British government’s pledge to back up individual investors’ deposits up to $80,000 failed to calm nerves, and also did not apply to bodies such as local governments and charities. (quoted from LA Times)