Help 2 FX questions
I am reading books these days and finding these 2 questions critical for
my understanding of the FX market. Can you take a look at them when you
have time? Thanks!
-
According to Real interest rate differential model, in a low risk
aversion environment investors tend to invest in a high interest rate
currency for carry trade and high yields. Thus the currency with high
interest rate would appreciate against a low interest rate currency.
However, this is against interest rate parity - it says the forward
exchange rate of the high interest rate currency against the low interest
rate currency is lower than the spot rate. what is your thought on this? -
The books also says investors tend to invest in low-interest-rate
currencies during a risk aversion environment because these currencies are
safer. So are low-interest-rate currencies generally regarded as safe
currencies? Or Safe currencies always have low interest rate?
The funding currency (currency with low rates) will, in the absence of arbitrage opportunities, necessarily have a forward exchange rate that takes into account the interest rate differential applicable for the said period of the forward (I presume you know how to calculate forward rates). However, for the high-yielding currencies, they're usually driven by some fundamentals (ie. strong economic performance as witnessed in the AUD now) which lead to those high yields (in the instance of the AUD, the RBA is keen to stem inflation). Given the attractive proposition in place, investors would therefore flock to the AUD (well, who wouldn't want to profit from a spread in excess of 4% in the case of the USDAUD if the exchange rate was fixed?). In so doing, as with anything governed by supply and demand, the AUD will therefore restore the balance by appreciating and buying fewer USD (in your words, the "high interest rate currency will appreciate against the a low interest rate currency") to counter the dominant trend of an increasing demand for the AUD (think of it this way: assuming the Fed Funds Rate stays constant; the higher the yield on the AUD, the lower USDAUD becomes to restore the imbalance). Theoretically, this should help restore interest rate parity.
There're what is widely known as "safe haven" currencies. Predominantly, they would be the USD and JPY, although some would include the CHF there. Considering the US and Japan have two of the world's largest economies, it makes sense for investors to park their money in USD- or JPY-denominated assets in uncertain times as the safety of their investments (through the currency denominated) are inextricably linked to the strength of the respective economies. Given the increase in demand for safe haven currencies in turbulent times, it makes sense for these currencies to yield low interest rates.
Thx for the answers first. You are saying that the AUD will appreciate against USD to restore interest rate parity. But based on interest rate parity, AUD should depreciate against USD because the forward is at discount. Could you please explain this?
Assume the USDAUD = 1.15 now. Hence, AUDUSD = 0.87 (ie.1/1.15). Let's assume hypothetically the calculations for a 6m forward for USDAUD=1.07. We could therefore infer a 6m forward AUDUSD=0.93 (ie.1/1.07).
I am not sure if this addresses your question, but in this instance, the high-yielding currency (ie.AUD) will have appreciated (against the USD) and the low-yielding currency (ie. USD) has depreciated (against the AUD). Specifically, in this context, the 6m forward of the USD actually trades at a discount while that of the AUD trades at a premium. Hence, it makes perfect sense for the USDAUD to depreciate (since it trades at a discount) while the AUDUSD would actually appreciate (trading at a premium).
Do you see we're effectively referring to two sides of the same coin? If USDAUD should depreciate (from 1.15 to 1.07), then AUDUSD must therefore appreciate (from 0.87 to 0.93) in accordance with the principles of no arbitrage!
In you example, what I am saying is that according to interest rate parity, 6m USDAUD should be 1.20 (more then 1.15) instead of 1.07, or AUDUSD should be 0.84 (less than 0.93). The value of the currency with the higher interest rate should go down according to interest rate parity.
Owww, that's why.
http://www.smbc-comics.com/index.php?db=comics&id=1863#comic
Owww, that's why.
http://www.smbc-comics.com/index.php?db=comics&id=1863#comic[/quote]
Pathetic!
For 2)
And this is probably amateurish, but do currencies then act like bonds? Low-interest rate currencies are perceived as being more stable and high-interest rate currencies more volatile?
I guess my question: is interest-rate a measure of a currencies volatility?
No, not necessarily. I don't think the AUD has been more volatile than the EUR lately even though the interest rate for AUD is 9 times that of the EUR.
Strictly speaking, there'd be some sort of relationship between volatility and interest rates (as denoted by the Black Scholes model, although that model assumes constant vols to begin with). However, there're many other factors that contribute to a currency's stability. In that sense, unlike bonds, you can't really conclude the quality of a currency based on its yields.
Note: You've got to further bear in mind currencies are subject to various monetary policies that could differ drastically depending on socioeconomic and political factors of the jurisdictions they belong to - some are freely floated, some are subjected to a "dirty float" while there're others which are fix pegged.
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