Financial Management AFIN253
Tutorial 12, Week 13
Homework questions.
Exchange rates cannot all appreciate together. At least one must depreciate. This is because they are measured against each other, they're a relative measure.
For example,
- If all countries' currencies appreciated except for the AUD, then the AUD must have depreciated.
- If all countries' currencies appreciated except for the USD, then the USD must have depreciated.
- If the USD depreciates then all other countries' currencies will appreciate against the USD. Indeed this is what happened during the global financial crisis (GFC) that started in 2007 when the US Federal Reserve (the US central bank) cut interest rates to zero, which led to a significant depreciation of the USD.
When someone says that they're "buying American dollars" (USD), what type of asset are they probably buying? They're probably buying:
If a person buys USD, they're usually just lending (depositing) USD in a bank, which is a form of short term debt.
If a big company or bank 'invests in USD', that will also mean that they're lending an amount denominated in USD. But usually these big institutions lend to each other in the money market which is the short-term wholesale debt market.
Question 312 foreign exchange rate, American and European terms
If the current AUD exchange rate is USD 0.9686 = AUD 1, what is the American terms quote of the AUD against the USD?
An American terms quote has the USD on the numerator (the top) of the fraction, so it's of the form: ##0.9686\frac{USD}{AUD}## which means 0.9686 USD per 1 AUD.
Question 313 foreign exchange rate, American and European terms
American terms currency quotes have the USD in the numerator (top) of the fraction, so they're of the form: ##0.80\frac{USD}{AUD}## which means 0.80 USD per 1 AUD or 0.8 USD = 1 AUD.
Since the AUD is in the denominator, when the AUD appreciates against the USD, the quote number will increase.
As the AUD appreciates or strengthens against the USD, one AUD buys more USD so the numerator ##(\text{0.80 USD})## must increase while the denominator ##(\text{1 AUD})## stays at one.
In these questions, focus on the denominator currency, also called the base currency, because if the base currency:
- Appreciates, the currency quote number will increase.
- Depreciates, the currency quote number will decrease.
In the example used above, ##0.80\frac{USD}{AUD}##, the AUD is the base currency and the USD is the term currency.
Note that if the AUD appreciates against the USD, the USD depreciates against the AUD.
Question 314 foreign exchange rate, American and European terms
American terms currency quotes have the USD in the numerator (top) of the fraction, so they're of the form: ##0.80\frac{USD}{AUD}## which means 0.80 USD per 1 AUD or 0.8 USD = 1 AUD.
Since the AUD is in the denominator, focus on what happens to the AUD when the USD appreciates. When the USD appreciates against the AUD, the AUD depreciates against the USD, and the quote number will decrease.
As the AUD depreciates or weakens against the USD, one AUD buys less USD so the numerator ##(\text{0.80 USD})## must decrease while the denominator ##(\text{1 AUD})## stays at one.
In these questions, focus on the denominator currency, also called the base currency, because if the base currency:
- Appreciates, the currency quote number will increase.
- Depreciates, the currency quote number will decrease.
In the example used above, ##0.80\frac{USD}{AUD}##, the AUD is the base currency and the USD is the term currency.
Question 315 foreign exchange rate, American and European terms
If the current AUD exchange rate is USD 0.9686 = AUD 1, what is the European terms quote of the AUD against the USD?
A European terms quote has the USD on the denominator (the bottom) of the fraction, so it's of the form: ##1.0324\frac{AUD}{USD}## which means 1.0324 AUD per 1 USD which is also the same as ##\text{AUD } 1.0324 = \text{USD } 1##.
Note that ##1.0324 = 1/0.9686##
Confusingly, a 'European terms' currency quote has nothing to do with the euro (EUR) currency.
Question 316 foreign exchange rate, American and European terms
European terms currency quotes have the USD in the denominator (bottom) of the fraction, so they're of the form: ##1.25 \frac{AUD}{USD}## which means 1.25 AUD per 1 USD or 1.25 AUD = 1 USD.
Since the USD is in the denominator, focus on what happens to the USD if the AUD appreciates. If the AUD appreciates against the USD, the USD depreciates against the AUD, and the currency quote number will decrease.
This is because as the USD depreciates or weakens against the AUD, one USD buys less AUD and the numerator ##(\text{1.25 AUD})## must decrease while the denominator ##(\text{1 USD})## stays at one.
In these questions, focus on the denominator currency, also called the base currency, because if the base currency:
- Appreciates, the currency quote number will increase.
- Depreciates, the currency quote number will decrease.
In the example used above, ##1.25\frac{AUD}{USD}##, the USD is the base currency and the AUD is the term currency.
Question 317 foreign exchange rate, American and European terms
European terms currency quotes have the USD in the denominator (bottom) of the fraction, so they're of the form: ##1.25 \frac{AUD}{USD}## which means 1.25 AUD per 1 USD or 1.25 AUD = 1 USD.
Since the USD is in the denominator, if the USD appreciates against the AUD, the currency quote number will increase.
As the USD appreciates or strengthens against the AUD, one USD buys more AUD so the numerator ##(\text{1.25 AUD})## must increase while the denominator ##(\text{1 USD})## stays at one.
In these questions, focus on the denominator currency, also called the base currency, because if the base currency:
- Appreciates, the currency quote number will increase.
- Depreciates, the currency quote number will decrease.
In the example used above, ##1.25\frac{AUD}{USD}##, the USD is the base currency and the AUD is the term currency.
Question 318 foreign exchange rate, American and European terms
The AUD is usually given as an American terms quote against the USD in Australia, for example is 0.9686 USD per AUD, so USD 0.9686 = AUD 1.
Question 319 foreign exchange rate, monetary policy, American and European terms
Investors expect the Reserve Bank of Australia (RBA) to keep the policy rate steady at their next meeting.
Then unexpectedly, the RBA announce that they will increase the policy rate by 25 basis points due to fears that the economy is growing too fast and that inflation will be above their target rate of 2 to 3 per cent.
What do you expect to happen to Australia's exchange rate in the short term? The Australian dollar is likely to:
The Australian dollar (AUD) may instantly appreciate on this news, since investors are more likely to buy the AUD and sell foreign currencies because they can get a higher return on their funds in Australia than what they first thought.
When the AUD appreciates against the USD, the European terms quote (AUD per 1 USD) will fall. This is because the USD is in the denominator and the USD is depreciating against the AUD.
Question 320 foreign exchange rate, monetary policy, American and European terms
Investors expect the Reserve Bank of Australia (RBA) to decrease the overnight cash rate at their next meeting.
Then unexpectedly, the RBA announce that they will keep the policy rate unchanged.
What do you expect to happen to Australia's exchange rate in the short term? The Australian dollar is likely to:
Even though the interest rate does not change, the surprise action of not lowering the interest rate means that AUD (debt assets) are a relatively better investment than investors thought. So the Australian dollar (AUD) may instantly appreciate on this news, since investors are more likely to buy the AUD and sell foreign currencies because they can get a higher return on their funds in Australia than what they first expected.
When the AUD appreciates against the USD, the European terms quote (AUD per 1 USD) will fall. This is because the USD is in the denominator and the USD is depreciating against the AUD.
Question 321 foreign exchange rate, monetary policy, American and European terms
The market expects the Reserve Bank of Australia (RBA) to increase the policy rate by 25 basis points at their next meeting.
Then unexpectedly, the RBA announce that they will increase the policy rate by 50 basis points due to high future GDP and inflation forecasts.
What do you expect to happen to Australia's exchange rate in the short term? The Australian dollar will:
The surprise action of raising the interest rate means that AUD (debt assets) are a relatively better investment than investors thought. So the Australian dollar (AUD) may instantly appreciate on this news, since investors are more likely to buy the AUD and sell foreign currencies because they can get a higher return on their funds in Australia than what they first expected.
When the AUD appreciates against the USD, the American terms quote (USD per 1 AUD) will rise. This is because the AUD is in the denominator and the AUD is appreciating against the USD.
Question 322 foreign exchange rate, monetary policy, American and European terms
The market expects the Reserve Bank of Australia (RBA) to decrease the policy rate by 25 basis points at their next meeting.
Then unexpectedly, the RBA announce that they will decrease the policy rate by 50 basis points due to fears of a recession and deflation.
What do you expect to happen to Australia's exchange rate? The Australian dollar will:
The surprise action of lowering the interest rate more than expected means that AUD (debt assets) are a relatively worse investment than investors thought. So the Australian dollar (AUD) may instantly depreciate on this news, since investors are more likely to sell the AUD and buy foreign currencies because they will get a lower return on their funds in Australia than what they first expected.
When the AUD depreciates against the USD, the American terms quote (USD per 1 AUD) will fall. This is because the AUD is in the denominator, so one AUD will buy less USD.
Question 323 foreign exchange rate, monetary policy, American and European terms
The market expects the Reserve Bank of Australia (RBA) to increase the policy rate by 25 basis points at their next meeting.
As expected, the RBA increases the policy rate by 25 basis points.
What do you expect to happen to Australia's exchange rate in the short term? The Australian dollar will:
There is no surprise interest rate movement, so there is no expected exchange rate movement. It is true that the Australian interest rate was raised, but this news should already have been reflected in the AUD exchange rate. The AUD would have appreciated in the past when the market first discovered the news, assuming that the market is efficient. But now there is no reason for the exchange rate to change since what was expected is exactly what occurred.
Sudden exchange rate fluctuations only occur due to surprises that the market did not already expect.
Question 245 foreign exchange rate, monetary policy, foreign exchange rate direct quote, no explanation
Investors expect Australia's central bank, the RBA, to leave the policy rate unchanged at their next meeting.
Then unexpectedly, the policy rate is reduced due to fears that Australia's GDP growth is slowing.
What do you expect to happen to Australia's exchange rate? Direct and indirect quotes are given from the perspective of an Australian.
The Australian dollar will:
No explanation provided.
Question 246 foreign exchange rate, forward foreign exchange rate, cross currency interest rate parity
Suppose the Australian cash rate is expected to be 8.15% pa and the US federal funds rate is expected to be 3.00% pa over the next 2 years, both given as nominal effective annual rates. The current exchange rate is at parity, so 1 USD = 1 AUD.
What is the implied 2 year forward foreign exchange rate?
Using the cross-currency interest rate parity (IRP) equation we can find the forward foreign exchange rate:
###F_{T, \text{AUD per USD}} = S_{0, \text{AUD per USD}}.\left( \dfrac{1+r_\text{AUD}}{1+r_\text{USD}} \right)^T### ###\begin{aligned} F_{2, \text{AUD per USD}} &= 1 \times \left( \dfrac{1+0.0815}{1+0.03} \right)^2 \\ &= 1.1025 \\ \end{aligned}###This is a European terms quote since the USD is in the denominator (the bottom of the fraction). So the European terms quote of the AUD is 1.1025 AUD per USD, which is the same as 1.1025 AUD = 1 USD.
Alternatively, if you began the interest rate parity equation using the American terms currency quotes, the answer can be converted into a European terms quote at the end.
###F_{T, \text{USD per AUD}} = S_{0, \text{USD per AUD}}.\left( \dfrac{1+r_\text{USD}}{1+r_\text{AUD}} \right)^T### ###\begin{aligned} F_{2, \text{USD per }\mathbf{\text{AUD}}} &= 1 \times \left( \dfrac{1+0.03}{1+0.0815} \right)^2 \\ &= 0.907029478 \\ \end{aligned}###This is an American terms quote since the USD is in the numerator (the top of the fraction). To get the European terms quote, invert the fraction.
###\begin{aligned} F_{2, \mathbf{\text{AUD}}\text{ per USD}} &= \dfrac{1}{F_{2, \text{USD per }\mathbf{\text{AUD}}}} \\ &= \dfrac{1}{0.907029478} \\ &= 1.1025 \\ \end{aligned}###As above, the European terms quote of the AUD is 1.1025 AUD = 1 USD.
Commentary
Notice that the AUD interest rate is higher than the USD interest rate, so the cross currency interest rate parity theorem requires that the AUD forward exchange rate be lower than the spot exchange rate. This is because any excess interest rate gains by borrowing cheap in the US and lending at a high rate in Australia will be offset by a loss caused by the depreciation of the AUD against the USD over time. So when the AUD loan proceeds are repatriated back to USD in the future, the gain will be equal to simply keeping the USD in a US bank at the low US interest rate. This will be true so long as all things remain equal, meaning there are no surprise interest rate changes, for example.