Currency

Wed, Jun 9, 2021 3-minute read

Curreny Market Mechanics

  • Exchange rates
  • Drivers of exchange rates
  • Central banks as currency guardians
  • Hedging currency risk
  1. Financial Investors: banks, financial institutions, security firms -> 5%
  2. Corporations: conducting business cross borders
  3. Travelers: for personal use

Pegged currencies FX reserve

Triangle arbitrage

British, Mexican, and Argentine crises all resulted in devaluations. Donald Tsang successfully defended the Hong Kong dollar peg

  • Over $5T of currencies are traded every day
  • 1971 marked the dawn of the modern currency market
  • Several countries peg their currencies to other currencies
  • Locked exchange rates are not actually set in stone but are government aspirations
  • Floating currencies move against one another in a matrix
  • The U.S. dollar is the world’s reserve currency and is the most heavily traded currency

Currency Valuation

The big Mac index uses the prices of Big Macs around the world compared to the price of a Big Mac in the U.S. as a proxy for currency valuation.

Main short-term drivers:

  • surprise changes in interest rates: when a central bank unexpectedly decreases interest rates, the government bond yields go down. This deters investment from around the world, reducing demand for that country’s currency. The currency, therefore, typically weakens.

  • surprise changes in inflation: central bank prints money, weaken a currency. Inflation - CPI, e.g. Indian Rupee When a central bank threatens to print a lot of money, the exchange rate will tend to depreciate. This is due to a surprise change in inflation expectations as printing money is inherently inflationary.

  • surprise changes in trade: GDP = C+I+G+(X-M) X: export, country exports -> foreign buyer needs to buy the currency of exporter, buy home currency M: import, importer needs to buy the currency of foreign seller by selling home currency

(X-M) positive -> drive the demand of exporter home currency e.g. oil price decreases -> RUBU weakened agaist USD as Russia is mainly rely on oil export

Long-term drivers: relative prices, as demostrated by the Big Mac index

  • The value of a currency is relative and not absolute
  • Trade-weighted baskets express currency overall strength and weakness
  • In the long run, the “law of one price” drives currency values
  • In the short run, these are three of the main drivers of currency valuation: surprise changes in interest rates/inflation/trade

Central banks and currencies

  • Central bankers control the levels of the currency markets

  • The standard inflation target is 2% for industrialized nations

  • Inflation can lead to a vicious cycle of pay increases leading to price increases: Workers expect prices to increase -> Workers demand pay increases -> Company wages go up -> Companies raise their prices

  • Deflation can lead to a vicious cycle of purchase deferrals and layoffs: Price declines -> Consumers defer purchases to avoid lower prices -> Company revenues decline -> Companies let go of workers to cut costs

Currency Risk

Japan is traditionally a heavy exporter, e.g. turbines and automobiles

The weakening of the domestic currency against the U.S. dollar provided a boom to exporting corporations. The immediate decline in sterling sent the stock market up as the index contained many large exporting corporations.

When one certaion currency weakens against another currency, this provides a tailwind to the revenues from that other currency region when translated back into that certain currency.

Tools to assess currency risk:

  1. Historic volatility of currency pair values
  2. Analyst forecasts of currency pairs

So-called “gold bugs” adore the durability, scarcity, and physical attractiveness of gold along with many other qualities of the metal.

  • Currency movements can wreak havoc on corporations and investors
  • Historic volatility and currency rate forecasts shed light on currency risk
  • Forward agreements lock in currency rates in the future, facilitating hedging and speculation
  • The fact that gold is scarce and cannot simply be printed has meant that it has retained value