Report on Exchange rate | The Lawyers & Jurists

Report on Exchange rate

Introduction:

An exchange rate is the current market price for which one currency can be exchanged for another. If the U.S. exchange rate for the Canadian Dollar is $1.60, this means that 1 American Dollar can be exchanged for 1.6 Bangladeshi Taka. Top of Form

The price of one currency in terms of another is called an exchange rate. Exchange rates are among the most important prices in an open economy.

There are two ways to express an exchange rate between two currencies (e.g. the $ and £ [pound]). One can either write $/£ or £/$. These are reciprocals of each other. Thus if E is the $/£ exchange rate and V is the £/$ exchange rate then E = 1/V.

For Example, on Jan 8, 1997 the following exchange rates prevailed,

E_$/£ = 1.69 which implies V_£/$= 0.59

V_¥/$ = 116. Which implies E_$/¥= 0.0086

we speak of an X-to-Y exchange rate of Z, this means that if we give up 1 unit of X, we get Z units of Y in return. If we want to know the Y-to-X exchange rate, we calculate it using the simple exchange rate formula:

Y-to-X exchange rate = 1 / X-to-Y exchange rate

Of course, the exchange rates we read in the paper or hear on radio or TV are not prices for X and Y or for oranges and lemons. Instead they’re relative prices for different currencies, but they work in the same fashion. On February 26, 2003 the U.S.-to-Japan exchange rate was 117 yen, so this means that you can purchase 117 Japanese yen in exchange for 1 U.S. dollar. To figure out how many U.S. dollars you can get for 1 Japanese yen, we can just use the formula:

Definition:

The price of one currency in terms of another is called an exchange rate. Exchange rates are among the most important prices in an open economy.

For Example, on Jan 8, 1997 the following exchange rates prevailed,

E_$/£ = 1.69 which implies V_£/$= 0.59

V_¥/$ = 116. Which implies E_$/¥= 0.0086

Part 1: Exchange Rates –

What are they and how are they calculated?

Like most other rates in economics, the exchange rate is essentially a price and can be analyzed in the same way we would a price. Take a typical supermarket price, say lemons are selling at the price of 3 for a dollar or 33 cents each. Then we can think of the dollar-to-lemon exchange rate as being 3 lemons because if we give up one dollar, we can get three lemons in return. Similarly, the lemon-to-dollar exchange rate is 1/3 of a dollar or 33 cents, because if you sell a lemon, you will get 33 cents in return.

So when we speak of an X-to-Y exchange rate of Z, this means that if we give up 1 unit of X, we get Z units of Y in return. If we want to know the Y-to-X exchange rate, we calculate it using the simple exchange rate formula:

Y-to-X exchange rate = 1 / X-to-Y exchange rate

Bangladesh-to-U.S. exchange rate = 1 / U.S.-to- Bangladesh exchange rate

Bangladesh -to-U.S. exchange rate = 1 / 117 = .00854

So this tells us that one Bangladeshi Taka is worth .00854 U.S. dollars, which is less than a penny.

Similarly if the Canadian dollar is worth .67 U.S. dollars, we have a Canada-to-U.S exchange rate of .67. If we want to know how many Canadian dollars we can buy with 1 U.S. dollar, we use the formula:

U.S.-to- Bangladesh exchange rate = 1/ Bangladesh -to-U.S. Exchange rate

U.S.-to- Bangladesh exchange rate = 1/0.67 = 1.4925 So one U.S. dollar can get us $1.49 in Bangladesh funds arbitrage.

To see why these relationships must hold, we’ll look at the wonderful world of

Y-to-X exchange rate = 1 / X-to-Y exchange rate

The American-to-Canadian exchange rate is 1.3659 as 1 U.S. Dollar can be exchanged for $1.3659 Canadian (so here the base is the U.S. Dollar). Our relationship implies that 1 Canadian Dollar must be worth (1 / 1.3659) U.S. Dollars. Using our calculator we find that (1/1.3659) = 0.7321, so the Canadian-to-American exchange rate is 0.7321 which is the same as the value in our chart. So the relationship does indeed hold.

Columns 5 and 6 are the same as columns 3 and 4, except now column 5 uses the Canadian Dollar as a base, and column 6 indicates how many Canadian Dollars you would get for 1 unit of each currency. We should not be surprised to see that 1 Canadian Dollar is worth 1 Canadian Dollar, as shown by the number “1.0000” on the bottom right corner of the chart.

From this chart, we can also see if there are any opportunities for arbitrage. If we exchange 1 American Dollar we can get 1.3659 Canadian. From the Units/BDT column, we see that we can exchange 1 Canadian dollar for 2.1561 Argentinean Real. Instead we’ll exchange our 1.3659 Canadian for Argentinean currency and receive 2.9450 Argentinean Real (1.3659*2.1561 = 2.9450). If we then turn around and exchange our 2.9450 Argentinean Real for U.S. Dollars at the rate of .3396, we will receive 1 U.S. Dollar in return (2.9450*0.3396 = 1). Since we started with 1 U.S. Dollar, we have not made any money from this currency cycle so there are no arbitrage profits.

Regarding your last question, the base of comparison is generally dictated by whatever country you are in, so Americans use the U.S. Dollar as a base, and Canadians generally use the Canadian Dollar. There are several currencies which are more valuable than the U.S. Dollar, including the Euro, the Bahamian Diner, the Latvian Lat, and the British Pound. I hope this answers your questions on exchange rates.

Today’s Exchange Rates

Code	Country	Units/USD	USD/Unit	Units/BDT	BDT/Unit
ARP	Argentina (Peso)	2.9450	0.3396	2.1561	0.4638
AUD	Australia (Dollar)	1.5205	0.6577	1.1132	0.8983
BSD	Bahamas (Dollar)	1.0000	1.0000	0.7321	1.3659
BRL	Brazil (Real)	2.9149	0.3431	2.1340	0.4686
BDT	Bangladesh(Dollar)	1.3659	0.7321	1.0000	1.0000

Part 2: Exchange Rates –

Arbitrage

Suppose the Algerian diners-to-Bulgarian lava exchange rate is 2. We would expect then that the Bulgarian-to-Algerian exchange rate would be 1/2 or 0.5. But suppose for a second that it wasn’t. Instead assume that the current market Bulgarian-to-Algerian exchange rate is 0.6. Then an investor could take five Algerian diners and exchange them for 10 Bulgarian lava. She could then take her 10 Bulgarian lava and exchange them back for Algerian diners. At the Bulgarian-to-Algerian exchange rate, she’d give up 10 lava and get back 6 diners. Now she has one more Algerian diner than she did before. This type of exchange is known as arbitrage. Since our investor gained a diner, and since we’re not creating or destroying any currency, the rest of the market must have lost a diner. This of course is bad for the rest of the market. We would expect that the other agents in the currency exchange market will change the exchange rates that they offer so these opportunities to get exploited are taken away. Still there is a class of investors known as arbitrageurs who try to exploit these differences.

Arbitrage generally takes on more complex forms than this, involving several currencies. Suppose that the Algerian diners-to-Bulgarian lava exchange rate is 2 and the Bulgarian lava-to-Chilean peso is 3. To figure out what the Algerian-to-Chilean exchange rate needs to be, we just multiply the two exchange rates together:

A-to-C = (A-to-B)*(B-to-C)

This property of exchange rates is known as transitivity. To avoid arbitrage we would need the Algerian-to-Chilean exchange rate to be 6 and the Chilean-to-Algerian exchange rate needs to be 1/6. Suppose it was only 1/5. Then our investor could again take five Algerian diners and exchange them for 10 Bulgarian lava. She could then take her 10 lava and get 30 Chilean pesos at the Bulgarian-to-Chilean exchange rate of 3. If she then exchanged her 30 Chilean pesos at the Chilean-to-Algerian rate of 1/5, she’d get 6 Algerian diners in return. Once again our investor has gained a diner and the rest of the market has lost one. For any three currencies A, B, and C, trading A for B, B for C and C for A is known as a currency cycle. The A-to-C exchange rate not only places restrictions on the C-to-A exchange rate, but it also places restriction on the A-to-B and B-to-C pair of exchange rates. Most of the time all the exchange rates on the market will be synchronized like this, but occasionally they’ll become out of sync and arbitrageurs can make a profit from currency cycles.

The relative prices of currencies are not set just to ensure that profitable currency cycles do not exist. Arbitrageurs only play a small, but important, role in the value of a currency. Currencies are simply a commodity, like any other, which has a price. Since the exchange rate is simply a price, it has the same basic determinants that any other price has: supply and demand. First we’ll look at supply.

4.1. Currency appreciation:

A currency appreciates with respect to another when its value rises in terms of the other. The dollar appreciates with respect to the yen if the ¥/$ exchange rate rises. If today the rate of ¥/$ is about 120 and tomorrow is 125, then we can say dollar is appreciated and yen is depreciated.

4.3. Effects of appreciation:

Foreigner pay more for the country’s products and domestic consumer pay less for foreign products.

4.4 Currency depreciation:

A currency depreciates with respect to another when its value falls in terms of the other. The dollar depreciates with respect to the yen if the ¥/$ exchange rate falls.

Note that if the ¥/$ rate rises, then its reciprocal, the $/¥ rate falls. Since the $/¥ rate represents the value of the yen in terms of dollars, this means that when the dollar appreciates with respect to the yen, the yen must depreciate with respect to the dollar.

4.5 Effects of depreciation:

When a country’s currency depreciates, foreigner find that its exports are cheaper and domestic residents find that imports from abroad are more expensive.

4.6 Currency devaluation:

Devaluation occurs when the central bank raises the domestic currency price of foreign currency, which means when the exchange rate system is fixed and the value of the currency will decrease that time devaluation will occur.

4.7 Currency revaluation:

Revaluation occurs when the central bank falls the domestic currency price of foreign currency, which means when the exchange rate system is fixed and the value of the currency will increase that time revaluation will occur.

The Example of rate of depreciation and appreciation:

The rate of appreciation is the percentage change in the value of a currency over some period of time.

Example #1: in

On Jan. 8 1997, E_¥/$ = 116

On Jan. 8 1996, E_¥/$ = 105

Use percentage change formula: (New value – Old value)/Old Value

Multiply by 100 to write as a percentage to get,

0.105 x 100 = +10.5%

Since we have calculated the change in the value of the $, in terms of yen, and since the percentage change is positive, this means that the dollar has appreciated by 10.5% with respect to the yen during the past year.

Example #2:

The rate of depreciation is the percentage change in the value of a currency over some period of time.

On Jan. 8 1997, E_£/$ = 0.59

On Jan. 8 1996, E_£/$ = 0.65

Use percentage change formula: (New value – Old value)/Old Value

Multiply by 100 to write as a percentage to get,

-0.092 x 100 = -9.2%

Since we have calculated the change in the value of the $, in terms of pounds, and since the percentage change is negative, this means that the dollar has depreciated by 9.2% with respect to the pound during the past year.

4.8 Arbitrage:

Arbitrage, generally means buying a product when its price is low and then reselling it after its price rises in order to make a profit. Currency arbitrage means buying a currency in one market (say New York) at a low price and reselling, moments later, in another market at a higher price.

4.9 Spot Exchange Rate:

The spot exchange rate refers to the exchange rate that prevails on the spot, that is, for trades to take place immediately.

4.10. Forward Exchange Rate:

The forward exchange rate refers to the rate which appears on a contract to exchange currencies either 30, 60, 90 or 180 days in the future.

4.11. Current Exchange Rate System or Arrangements:

The IMF currently classifies exchange rate arrangements into eight separate regimes:

i. Exchange arrangements with no separate legal arrangements tender:

The currency of another country circulates as the sole legal tender or the country belongs to a monetary or currency union in which the same legal tender is shared by the members of the union. Examples include Ecuador, Panama using the US dollar and the euro zone members’ countries sharing the common currency, the euro.

ii. Currency board arrangement:

A monetary regimes based on an explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligation. Example: Hong Kong fixed to the US dollar and Estonia to the euro.

iii. Other conventional fixed peg arrangement:

The country pegs its currency at a fixed rate to a major currency or a basket of currencies where the exchange rate fluctuates within a narrow margin of less than ±1 percent, example: China, Malaysia and Saudi Arabia.

iv. Pegged exchange rate within horizontal bands:

The value of the currency is maintained within margins of fluctuations around a formal fixed peg that are wider than at least ±1 percent, example, Denmark, Egypt and Hungary.

v. Crawling pegs:

The currency is adjusted periodically in small amount at a fixed, preannounce rate. Bolivia, Costa Rica following this.

vi. Exchange rates within crawling bands:

The currency is maintained within certain fluctuation margins around a central rate that is adjusted periodically at a fixed preannounce rate. For example: Israel, Romania and Venezuela.

vii. Managed floating with no preannounce path for the exchange rate:

The monetary authority influences the movements of the exchange rate through active intervention in the foreign exchange market without specifying or recommitting to, a preannounce path for the exchange rate. Example: Algeria, Singapore, and Thailand.

viii. Independent Floating:

Exchange rate is determined by the market’s demand and supply. Government cannot intervene in the foreign exchange market. For example, USA, UK, Japan, Canada etc.

4.12. Why firms forecast exchange rates:

Some corporate functions for which exchange rates forecast are necessary:

Hedging decision:

Þ Whether to hedge future payables and receivables in/foreign currencies./ determined by its forecasts of foreign currency values.

Þ USA co. ® import ® plan to pay ® Mexico ® in 90 days. If the forecasted value of peso ® in 90 day ® below ® 90 day forward rate ® decide not to hedge.

Short term financing decision:

Þ Currency borrow ® exhibit ® (i) low interest rate (ii) weaken in value

Þ One co. ® borrow ® yen to finance in USA low interest rate ® if the yen depreciates ® can pay back fewer dollar that is dependent on the future value of the yen.

Short term investment decision:

Þ Excess cash short term period co. can deposit

Þ High interest rate strength in value

Þ Depositing cash in British Bank if £ appreciates against the $- £ will be withdrawn exchange for $.

Capital budgeting decision:

Þ Capital budgeting analysis completed estimated cash flows parent’s local currency.

Long term financing decision:

Þ Prefer currency borrowed depreciate against currency receiving from sales.

Earnings assessment:

Þ Subsidiary earnings consolidated translated currency representing parent firm’s home currency.

4.13. Forecasting Techniques:

(1) Technical forecasting:

Þ Historical exchange rate ® predict future values ® statistical analysis

Þ Appears to be widely used by speculators who attempt to capitalize on day to day ex. Rate movements.

(2) Fundamental forecasting:

Þ Based on fundamental relationship ® economic variables® (i) inflation

(ii) Income growth

(3) Market based forecasting:

Þ Forecasts from market indicators ®The spot rate ® The forward rate

(4) Mixed forecasting:

Þ A combination of forecasting techniques.

Part 3: Exchange Rates –

Supply

Basic econonomic theory teaches us that if the supply of a good increases, and nothing else changes, the price of that good will decrease. If the supply of a country’s currency increases, we should see that it takes more of that currency to purchase a different currency than it did before. Suppose there was a big jump in the supply of the Canadian dollar. We would expect to see the Canadian dollar become less valuable relative to other currencies. So the Canadian-to-U.S. Exchange rate should decrease, from 67 cents down to, say, 50 cents. Each Canadian dollar would give us less American dollars than it did before. Similarly, the U.S.-to-Canadian exchange rate would increase from $1.49 to $2.00, so each U.S. dollar would give us more Canadian dollars than it did before, as a Canadian dollar is less valuable than it used to be.

Why would the supply of a currency increase?

Currencies are traded on the foreign exchange market, and the supply of a currency on that market will change over time. There are a few different organizations whose actions will cause a rise in the supply of the foreign exchange market:

1. Export Companies

Suppose a South African farm sells the cashews it produces to a large Japanese firm. It is likely that the contract will be negotiated in Japanese yen, so the farm will receive its revenue in a currency with limited use outside of Japan. Since the company needs to pay it’s employees in the local currency, namely the South African rand, the company would sell its yen on a foreign exchange market and buy rands. The supply of Japanese yen on the foreign exchange market will increase, and the supply of South African rends will decrease. This will cause the rand to appreciate in value (become more valuable) relative to other currencies and the yen to depreciate.

2. Foreign Investors

A German automobile manufacturer wants to build a new plant in Windsor, ON, Canada. To purchase the land, hire construction workers, etc., the firm will need Canadian dollars. However most of their cash reserves are held in euros. The company will be forced to go to the foreign exchange market, sell some of its euros, and buy Canadian dollars. The supply of euros on the foreign exchange market goes up, and the supply of Canadian dollars goes down. This will cause Canadian dollars to appreciate and euros to depreciate.

Foreign investment does not have to be in tangible goods such as land. If German investors buy Canadian stocks, such as stocks listed on the Toronto Stock Exchange or purchase Canadian dollar bonds, we will have the same situation as above.

3. Speculators

Like the stock market, there are investors who try to make a fortune (or at least a living) by buying and selling currencies. Suppose a currency investor thinks that the Mexican peso will depreciate in the future, so it will be less valuable than other currencies than it is now. In that case, she is likely to sell her pesos on the foreign exchange market and buy a different currency instead, such as the South Korean won. The supply of pesos goes up and the supply of won goes down. This causes pesos to depreciate, and won to appreciate.

Note the self-fulfilling nature of the beliefs investors hold. If investors feel that a currency will depreciate in the future, they will try to sell it today. Since the currency is being sold by investors, the supply of it will go up, and the price of it will decrease. The investor thought that the currency would depreciate, she acted on that belief and sold her currency, and the act of selling caused the depreciation to take place. Self-fulfilling prophecies such as this one are quite common in economics.

4. Central Bankers

The central bank of the United States is the Federal Reserve, more commonly known as “The Fed”. One of the responsibilities of the Fed is to control the supply, or the amount, of currency in a country. The most obvious way to increase the supply of money is to simply print more currency, though there are much more sophisticated ways of changing the money supply. If the Fed prints more 10 and 20 dollar bills, the money supply will increase. When the government increases the money supply, it is likely some of this new money will make its way to the foreign exchange market, so the supply of U.S. dollars will increase there as well.

A central bank will often directly increase the supply of money on the foreign exchange markets. Central banks like the Fed keep a supply of most (if not all) currencies in reserve and will often use them to influence the exchange rate. If the Fed decides that the U.S. dollar has appreciated in value too much relative to the Japanese yen, it will sell some of the U.S. dollars it has in reserve and buy Japanese yen. This will increase the supply of dollars on the foreign exchange market, and decrease the supply of yen, causing a depreciation in the value of the dollar relative to the yen. Of course, the Fed cannot do this as much as it would like, because it may end up running out of some currencies. As well, the Japanese central bank (named the Bank of Japan) could decide that the Fed is manipulating the price of the yen too much and the Bank of Japan could counteract the Fed by selling yen and by buying dollars.

These are the organizations who will increase the supply of currency on the exchange market. Now we’ll investigate the demand side of foreign exchange markets.

Part 4: Exchange Rates –

Demand

Why would the demand for a currency increase?

Not surprisingly pretty much the same organizations who caused supply changes will cause demand changes. They are as follows:

1. Import Companies

A British retailer specializing in Chinese merchandise will often have to pay for that merchandise in Chinese yuan. So if the popularity of Chinese goods goes up in other countries the demand for Chinese yuan will go up as retailers purchase yuan to make purchases from Chinese wholesalers and manufacturers.

2. Foreign Investors

As before a German automobile manufacturer wants to build a new plant in Windsor, ON, Canada. To purchase the land, hire construction workers, etc., the firm will need Canadian dollars. So the demand for Canadian dollars will rise.

3. Speculators

If an investor feels that the price of Mexican pesos will rise in the future, she will demand more pesos today. This increased demand leads to an increased price for pesos.

4. Central Bankers

A central bank might decide that its holdings of a particular currency are too low, so they decide to buy that currency on the open market. They might also want to have the exchange rate for their currency decline relative to another currency. So they put their currency on the open market and use it to buy another currency. So Central Banks can play a role in the demand for currency.

Supply and demand are often thought of as being two sides of the same coin. Here we see that this is the case, as in every transaction there is a buyer and a seller, or in other words, a demander and a supplier.

Now we know what agents can cause price changes and for what reasons. We can use our knowledge to analyze what happens in the “real world”. An interesting case is the Canadian-to-American exchange rate. Due to the geographical proximity and economic integrations of the two countries the Canadian-to-American exchange rate is often examined. The sharp decline in the value of the Canadian dollar relative to the American one is widely discussed in the news, so we’ll discuss it now.

Part 5: Case Study: Bangladesh –

Introduction:

In January 1990 the Bangladesh-to-U.S. exchange rate was around 85 American cents. Less than nine years later, the Canadian dollar had depreciated to 65 cents. This substantial drop in the value of the Canadian dollar has been quite upsetting to many Canadians. Almost every Canadian spends a large fraction of his/her income on American goods and many take vacations in the United States. Since the savings of most Canadians are in assets priced in Canadian dollars, their savings could now buy much fewer American goods and services. This was particularly noticeable to Canadian seniors who spend much of the winter in Arizona and Florida. The following chart shows how the Canadian-to-American exchange rate has declined since1990:

Now we can see the problem, we can investigate what caused this drop. The rapid decline of the Canadian dollar can be explained by the supply and demand framework illustrated in the previous two sections of this article. Here are three factors which caused a change in supply and/or demand and subsequently a devaluation of the Canadian dollar.

Part 6: Case Study: Bangladesh –

Commodity Price

Factor 1: Commodity prices.

More so than any other industrialized country, Canada’s economy relies heavily on the export of raw materials such as lumber, natural gas, and agricultural products. The Bank of Canada has developed a Commodity Price Index, which tracks changes in the prices of commodities which Canada exports. The breakdown of the elements in the Commodity Price Index is roughly:

Category	Percentage
Energy	34.9
Food	18.8
Metals	14.4
Minerals	2.3
Forest Products	29.6

Commodities such as these represent almost 40 percent of Canadian exports. As shown in the following chart, the Commodity Price Index fell sharply several times between 1990 and 2002, particularly during the Asian crisis of 1997-1998:

It would appear that both the exchange rate and the Commodity Price Index suffered similar declines during 1997 and 1998. I calculated the correlation coefficient between the exchange rate and the (unsealed) Commodity Price Index between January 1997 and December 1998. The correlation coefficient between the two was a whopping 0.94, indicating a particularly strong positive relationship between the two. We cannot infer from this that the drop in the Commodity Price Index necessarily caused a drop in the exchange rate, but we can say that the two changed in the same direction most months during this period. This strong relationship did not occur before or after this period. The correlation coefficient for 1990-1996 was -0.31, and for 1999-2002 was 0.29.

Now consider why this relationship might occur. After a reduction in lumber prices, an American construction company now needs less Canadian dollars to purchases its Canadian lumber. The reduction in lumber prices will likely cause the company to increase its purchases, but their total expenditures will likely be lower than they were before. Because of this American construction companies will need to buy less Canadian dollars on the foreign exchange market to get the lumber they need. The demand for Canadian dollars will decrease, and the price of the Canadian dollar relative to all currencies including the U.S. one will go down. We would expect that all else being equal, a reduction in commodity prices will occur at the same time as a reduction in the exchange rate. This appears to have happened during the Asian crisis of 1997-1998 and possibly since then as well.

This reduction in commodity prices represents only a partial explanation for the decline in the Canadian dollar.

Part 7: Case Study: Bangladesh –

Interest Rates

Factor 2: Interest Rates

During the early 1990s, the Bank of Canada (BoC), Canada’s central bank, embarked on a policy to lower interest rates, particularly interest rates on government bonds. The BoC succeeded and Canadian interest rates dropped much faster than American rates. The Canadian prime rate of interest was around 14% during 1990 while the American prime rate was around 10%. We usually compare interest rates by basis points, where 100 basis points a difference of 1%, say between 5% and 6% or between 17% and 18%. So here we have a 400 point difference in rates. By 1997 the Canadian prime rate of interest was 375 points lower than the American one. The following chart shows the difference between the Canadian rate and the American one:

Changes in interest rates can have a drastic effect on exchange rates. Investors interested in purchasing a security that pays interest, such as a bond, will buy the bond that gives them the highest interest rate, all else being equal. Since Canadian bonds had a lower interest rate than American bonds, investors were more interested in purchasing American bonds, and less interested in Canadian ones. In order to purchase American bonds, they would need to buy American dollars on the foreign exchange market, causing a reduction in the supply of U.S. dollars and a rise in their value relative to other currencies such as the Canadian one. If Canadians are buying U.S. bonds, they’ll be selling Canadian dollars and buying American ones, so we’ll see an increase in the supply of Canadian dollars and a decline in their value.

We should then expect to see periods where the exchange rate and the interest rate move in the same direction. Visually it would be helpful to plot them both on the same set of axes. To do this I had to perform a scaling operation on the interest rate gap. By taking the gap, dividing it by 50 then adding 0.7 to this figure, I was able to plot both on the same chart:

The exchange rate is the blue line which starts higher and the interest rate gap is the purple line which starts lower. Note how both decline until 1997. The correlation coefficient for the interest rate gap and the exchange rate from January 1990 to December 1996 is 0.73; the two were highly positively related during this period. However during the Asian crisis of 1997-1998 the two went in opposing directions and the correlation coefficient was -0.91. Changes in the interest rates gap have not gone in the same direction as changes in the exchange rate since 1998 as the correlation coefficient is -0.75. It would appear that if we’re looking for reasons why the Canadian dollar may have been weak since 1998, we’ll have to look elsewhere for an answer.

Part 8: Case Study: Bangladesh –

International Factors

Factor 3: International Factors and Speculation

During 1997 and 1998, the economies of most Asian countries went into steep decline which became known as the Asian Crisis. The Asian crisis had a far greater impact on Canada than it did on the United States. Exports take up a much smaller portion of the U.S. economy than they do of the Canadian economy. So the American dollar is much more insulated to international events than the Canadian dollar. Canada also exports a large amount of construction materials to Asian countries, so when the economies of these countries went into severe decline, new construction became non-existent so raw materials were no longer demanded. This drop in the demand for commodities caused a decline in the price of the Canadian dollar relative to other non-Asian currencies, unnecessary risk. Investors during times of international turmoil prefer to invest in large countries that are more insulated from turmoil in other countries. The United States is a haven for investors trying to avoid this type of uncertainty, whereas smaller open economies like Canada are not. So not surprisingly the Canadian dollar declined during the Asian crisis.

1. THE Bush Election win:

The Republicans are seen as a party which will create an environment positive for investors. It is conceivable that many international investors moved their money from Canada to the United States when the White House went from Democratic to Republican control.

2.International Uncertainty:

As mentioned before investors will flock to a country like the United States during time of unrest. Investors have been worried that a global recession might occur during the beginning of this decade. Terrorist threats and military actions in Afghanistan and Iraq may have caused investors to put their money into large countries like the United States.

The Beliefs of Currency Speculators:

Many currency speculators felt that the Canadian dollar would continue to decline in the future. Many investors did not want to be part of a sinking ship, so they sold their holdings of Canadian dollars, further reducing the price. If investors feel that the Canadian dollar will improve in the near future, they will jump back on the bandwagon by buying Canadian dollars and the value of the Canadian dollar will rise. It appears this is what has been happening in the beginning of 2003.

Next week I’ll be adding pages on Purchasing Power Parity, Fixed vs. Floating Rates, and Currency Unions.

volatility :

(thermodynamics) The quality of having a low boiling point or subliming temperature at ordinary pressure or, equivalently, of having a high vapor pressure at ordinary temperatures.

Investment Dictionary :Volatility :

1. A statistical measure of the dispersion of returns for a given security or market index. Volatility can either be measured by using the standard deviation or variance between returns from that same security or market index. Commonly, the higher the volatility, the riskier the security.

2. A variable in option-pricing formulas showing the extent to which the return of the underlying asset will fluctuate between now and the option’s expiration. Volatility, as expressed as a percentage coefficient within option-pricing formulas, arises from daily trading activities. How volatility is measured will affect the value of the coefficient used.

Investopedia Says:

In other words, volatility refers to the amount of uncertainty or risk about the size of changes in a security’s value. A higher volatility means that a security’s value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short time period in either direction. Whereas a lower volatility would mean that a security’s value does not fluctuate dramatically, but changes in value at a steady pace over a period of time.

One measure of the relative volatility of a particular stock to the market is its beta. A beta approximates the overall volatility of security’s returns against the returns of a relevant benchmark (usually the S&P is used). For example, a stock with a beta value of 1.1 has historically moved 110% for every 100% move in the benchmark, based on price level. Conversely, a stock with a beta of .9 has historically moved 90% for every 100% move in the underlying index.

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Wikipedia :

Volatility is the measure of the state of instability.

· Volatility (finance) frequently refers to the standard deviation of the change in value of a financial instrument with a specific time horizon. It is often used to quantify the risk of the instrument over that time period. Volatility is typically expressed in annualized terms, and it may either be an absolute number ($5) or a fraction of the initial value (5%).

· Volatility (chemistry) is a measure of the tendency of a liquid (or solid) to evaporate into a gaseous form. Higher volatility indicates a higher tendency to evaporate and a lower volatility means that it has a lower tendency to evaporate.

· Volatility (finance), a measure of the risk in a financial instrument

In chemistry:

Volatility (chemistry), a measure of the tendency of a substance to vaporize. It has also been defined as a measure of how readily a substance vaporizes.
Volatiles, a group of compounds with low boiling points that are associated with a planet’s or moon’s crust and/or atmosphere
Volatile liquids, with a high vapor pressure or low boiling point
Volatile organic compounds, organic compounds that can evaporate at normal temperature and pressure, and are often regulated by governments
Volatile anesthetics, a class of anesthetics which evaporate easily
Volatile substance abuse, the abuse of household inhalants containing volatile compounds
Volatile oil, also known as essential oil, an oil derived from plants with aromatic compounds used in cosmetics and flavoring
Volatile acidity, a term used in winemaking to indicate an unacceptably high level of acid or vinegar and baking soda.

In computer science:

Volatile variables, variables that can be changed by an external process
Volatile memory, memory that lasts only while the power is on (and thus would be lost after a restart)

In geology:

Volatiles, the volatile compounds of magma (mostly water vapor) that affect the appearance and strength of volcanoes

Other uses:

Volatile Games, a video games maker

Relative volatility :

Relative volatility is a measure comparing the vapor pressures of the components in a liquid mixture of chemicals. This quantity is widely used in designing large industrial distillation processes.^{<href=”#wp-_note-Kister>[1]<href=”#wp-_note-Perry>[2]<href=”#wp-_note-SeaderHenley>[3]} In effect, it indicates the ease or difficulty of using distillation to separate the more volatile components from the less volatile components in a mixture. By convention, relative volatility is usually denoted as ?.

Relative volatilities are used in the design of all types of distillation processes as well as other separation or absorption processes that involve the contacting of vapor and liquid phases in a series of equilibrium stages.

Relative volatilities are not used in separation or absorption processes that involve components reacting with each other (for example, the absorption of gaseous carbon dioxide in aqueous solutions of sodium hydroxide).

Definition

For a liquid mixture of two components (called a binary mixture) at a given temperature and pressure, the relative volatility is defined as

where:
?	= the relative volatility of the more volatile component i to the less volatile component j
*y_i*	= the vapor-liquid equilibrium concentration of component i in the vapor phase
*x_i*	= the vapor-liquid equilibrium concentration of component i in the liquid phase
*y_j*	= the vapor-liquid equilibrium concentration of component j in the vapor phase
*x_j*	= the vapor-liquid equilibrium concentration of component j in the liquid phase
(y / x)	= K commonly called the *K value* or *vapor-liquid distribution ratio* of a component

When their liquid concentrations are equal, more volatile components have higher vapor pressures than less volatile components. Thus, a K value (= y / x) for a more volatile component is larger than a K value for a less volatile component. That means that ? ? 1 since the larger K value of the more volatile component is in the numerator and the smaller K of the less volatile component is in the denominator.

? is a unit less quantity. When the volatilities of both key components are equal, ? = 1 and separation of the two by distillation would be impossible under the given conditions. As the value of ? increases above 1, separation by distillation becomes progressively easier.

Schematic diagram of a typical large-scale industrial distillation column

A liquid mixture containing two components is called a binary mixture. When a binary mixture is distilled, complete separation of the two components is rarely achieved. Typically, the overhead fraction from the distillation column consists predominantly of the more volatile component and some small amount of the less volatile component and the bottoms fraction consists predominantly of the less volatile component and some small amount of the more volatile component.

A liquid mixture containing many components is called a multi-component mixture. When a multi-component mixture is is distilled, the overhead fraction and the bottoms fraction typically contain much more than one or two components. For example, some intermediate products in an oil refinery are multi-component liquid mixtures that may contain the alkane, alkene and alkyne hydrocarbons ranging from methane having one carbon atom to decanes having ten carbon atoms. For distilling such a mixture, the distillation column may be designed (for example) to produce:

An overhead fraction containing predominantly the more volatile components ranging from methane (having one carbon atom) to propane (having three carbon atoms)
A bottoms fraction containing predominantly the less volatile components ranging from isobutane (having four carbon atoms) to decanes (ten carbon atoms).

Such a distillation column is typically called a depropanizer. The designer would designate the key components governing the separation design to be propane as the so-called light key (LK) and isobutane as the so-called heavy key (HK). In that context, a lighter component means a component with a lower boiling point (or a higher vapor pressure) and a heavier component means a component with a higher boiling point (or a lower vapor pressure).

Thus, for the distillation of any multi-component mixture, the relative volatility is often defined as

Large-scale industrial distillation is rarely undertaken if the relative volatility is less than 1.05.

The values of K have been correlated empirically or theoretically in terms of temperature, pressure and phase compositions in the form of equations, tables or graph such as the well-known De Priester charts.

K values are widely used in the design of large-scale distillation columns for distilling multi-component mixtures in oil refineries, petrochemical and chemical plants, natural gas processing plants and other industries.

IMPACT OF MACROECONOMIC ON EXCHANGE RATE VOLATILITY:

The impact of the US and European macroeconomic news on the USD/BDT volatility was examined by using the Flexible Fourier Form method. News increased volatility significantly, and the US news was the most important. The much-tested hypothesis of bad news having a greater impact on volatility was re-confirmed. The announcements were also divided into two categories, the first containing the news that gave conflicting information on the state of the economy and the other containing the news that were consistent. Conflicting news were found to increase volatility significantly more and faster than consistent news. (JEL: G14, C14, C12)

1.Introduction :

According to the Triennal Central Bank Survey by the Bank for International Settlements, the daily turnover in the international foreign exchange markets was approximately 1 800 billion US dollars in 2004 (BIS 2005). These markets are not only the biggest markets in the world, but they also keep growing very fast. In their earlier survey in 2001, BIS reported the volume of daily transactions to be 1200 billion US dollars, making the growth of these markets to be 36% with constant exchange rates (BIS 2005). The dynamics of foreign exchange markets have been examined a lot, but yet we know quite Httle about these markets. The macro models are usually successful in explaining exchange rate dynamics in the long run, but explaining shortrun (a week or a few months) and very short-run (intraday) dynamics with these models has been very challenging (Meese and Rogoff 1983). From the viewpoint of these models it seems to be quite unclear what happens to the exchange rate in the short and very short run. In this context market microstructure models seem to work better and are more promising.

In this paper we study the connection between exchange rates and macro fundamentals in the short run by estimating the impact of macroeconomic announcements on USD/EUR exchange rate volatility. We use a new 5-minute frequency data set from 28 October 2003 to 20 January 2004 and estimate the impact of news with the Flexible Fourier Form method introduced by Andersen and Bollerslev in 1997. The announcements were collected from Bloomberg WECO (World economic calendar), and they are news of the macroeconomic fundamentals like GDP figures, interest rates and consumer confidence indexes. We study the effect between different groups of news and try to get new information of the asymmetries in the impact of different news categories.

The results suggest that news increase volatility significantly, the US news being the most important. Negative news seem to have a bigger effect than positive news, but more importantly, conflicting news increase the volatility more compared to consistent news. By conflicting news we mean the moments when more than one macro news were announced at the same time, and some of the figures were overestimated and some underestimated compared to the market forecast. Consistent news on the other hand means the moments when only either positive or negative news arrived to the markets. We also examine the effect of the news whose market forecast equals the announced figure and according to our results also this kind of so called “no-news” has a strong positive effect on volatility.

Many explanations for high (price) volatility in exchange rate markets have been proposed. Numerous theoretical and empirical models have highlighted important features of the market structure, which partly explain the dynamics of the foreign exchange markets. According to our results, the macroeconomic fundamentals are also one piece of the volatility puzzle. Because of the different motives of the heterogeneous agents (Farmer and Joshi 2002), different trading strategies (Admati and Pfleiderer 1988), psychological choices (Barberis et al. 1998) and different abilities to forecast and analyse the impact of the new information on the value of the exchange rates (Damodaran 1985), the new information does not only cause a jump in the exchange rate, but also higher volatility after the news.

The main finding of this empirical study is that it is the coherence of the signal that matters. When several macro figures are announced at the same time we could imagine that this would help the agents to get a broader picture of the state of the economy. However, this seems not to be the case if the agents do not get a clear positive or negative signal. If some figures are underestimated and some overestimated, it seems that the market agents have more difficulties in evaluating the effect of the news. This causes excess volatility to the exchange rates.

2. The impact of macro announce ments on USD/EUR volatility :

2. 1 Earlier studies:

The empirical literature on the impact of news on exchange rate volatility has expanded greatly in recent decades. The earliest studies in the 1 980s used daily return data and simple regressions, and did not get very promising results (Aggarwal and Schirm 1992). Since the 1990s the availability of high-frequency data, numerous variations of GARCH-models (Bollerslev et al. 1992), and the methods of filtering intraday volatility periodicity and other market anomalies (Andersen and Bollerslev 1997) have improved the analysis of the impact of news on exchange rate volatility.

The impact of news on exchange rate returns’ and the volatility of returns2 have been examined extensively. The most studied exchange rate has been DEM/USD, but also GBP/USD (for example Goodhart et al. 1993) and YEN/ USD (for example Melvin and Yin 2000) have been examined. Usually the news has been Reuter’s headlines or scheduled macro announcements, but also the headlines of financial newspapers have been studied (for example, by Chan et al. 2001).

The results indicate that the news cause a jump in the level of the exchange rate, and increase the volatility of returns from an hour to two hours after the arrival of information (Andersen and Bollerslev 1998). The latest results of Evans and Lyons (2005) suggest, however, that the impact of news remains significant for several days. According to the earlier results, US news increase DEMAJSD volatility more than news

Definition

IMPACT OF MACROECONOMIC ON EXCHANGE RATE VOLATILITY:

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