8. Exchange Rates

The indirect exchange rate (foreign currency units/1 domestic currency unit) is normally denoted by the term e-prime (e′) and is simply the reciprocal of (e). A strong currency would have a high value for e′, as many units of foreign currency may be purchased with each unit of domestic. A weak currency would have a low value for e′. Currencies are quoted inconsistently in regular usage, sometimes with the direct rate (e) and sometimes with the indirect rate (e′), leaving interpretation dependent on context. Usually, the rate quote will avoid values less than 1 unit, so, for example, in the United States, the USD/China rate would be an indirect quote (e′) of “6.2,” meaning 6.2 China RMB to 1 USD, and the euro would be quoted in direct terms (e), as “1.3,” meaning 1.3 US dollars to 1 euro. A helpful device to remember how e is calculated is “Don’t Forget, Domestic over Foreign!”

A country’s currency and its bonds are both essentially liabilities of the country’s government, the main differences being that the former is the most liquid, and the latter pays interest. Short-term government bonds traded in a highly liquid market may in a sense be considered interchangeable with currency, from this perspective. See John Hussman, Ph.D., “Why the Federal Reserve is Irrelevant,” Hussman Funds Research & Insight, August 2001. http://​www.​hussmanfunds.​com/​html/​fedirrel.​htm

“Bank of Japan injects $76bn into markets as yen rises,” BBC News, March 17, 2011, accessed April 2, 2011, http://​www.​bbc.​co.​uk/​news/​business-12768673

We will occasionally use personal pronouns, in examples such as “we” and “their currency,” rather than sticking with “the domestic country” and “the foreign country’s currency” as a rhetorical device. This can sometimes make it easier to conceptualize the point being made.

This topic is covered in more detail in Chap.​ 13.

Akila Weerapana, “Lecture 5: Exchange Rate Systems,” Wellesley College, 2003.

Barry Eichengreen, “Sterling’s Past, Dollar’s Future: Historical Perspectives on Reserve Currency Competition,” Tawney Lecture delivered to the Economic Historical Society, Leicester: United Kingdom, April 10, 2005.

We might also say “with the Korean won strengthening.” All currency movements are relative by definition. A strengthening of A relative to B always means a weakening of B relative to A.

We are using extraordinarily high rates of interest here (2 % per month is roughly 27 % per annum, compounded) in order to illustrate our point more clearly. Interest rates are in practice normally quoted in annualized terms—we are giving the effective rate for a 30-day term here in order to keep the calculations simple in this first example.

We have rounded the expected exchange rate to two digits to keep the example simple.

Ian Giddy, “An Integrated Theory of Exchange Rate Equilibrium,” University of Michigan, May 1975.

For example, at http://​www.​forexspace.​com/​currency-rates/​EUR-USD/​forward-rates or http://​www.​fxstreet.​com/​rates-charts/​forward-rates/​. In print, the Wall Street Journal publishes forward rates daily. Note that forward rates are normally quoted in forward points, or “pips,” which are 1/1,000ths of a unit denomination of the “foreign” currency (the denominator currency, e.g., USD in EUR/USD). Forward rate quotes, in “pips,” are calculated as forward points = |(forward price − spot price)* 1,000|. The sign is generally omitted.

Akila Weerapana, “Lecture 5: Exchange Rate Systems,” Wellesley College, 2003.

The RMB was held between 6.82 and 6.84 per USD from July 2008 through July 2010.

H.K. Behera, V. Narasimhan, and K.N. Murty, “Relationship Between Exchange Rate Volatility and Central Bank Intervention: An Empirical Analysis for India,” South Asia Economic Journal, Research and Information System for Developing Countries, New Delhi, India and Institute of Policy Studies, Colombo, Sri Lanka, June 2008, accessed April 4, 2011. http://​www.​igidr.​ac.​in/​~money/​mfc_​08/​Relationship%20​bet%20​Exchange%20​rate%20​Volatility.​.​.​%20​Behera,%20​Narsimhan%20​.​.​.​%20​Murty.​pdf

Toru Fujioka and Mayumi Otsuma, “G-7 Sells Yen in First Joint Intervention Since 2000 to Ease Japan Crisis,” Bloomberg, March 18, 2011, 8:38 AM ET, accessed April 4, 2011, http://​www.​bloomberg.​com/​news/​2011-03-18/​g-7-intervenes-to-weaken-yen-as-surging-currency-threathens-quake-recovery.​html

We thus avoid factoring in default risk, which although real and often significant, is not part of our current analysis.

Again, our definition of “risk-free” here encompasses the currencies of countries that have traditionally been considered safe havens, for example, the USA, Japan, Germany, Switzerland, and the Eurozone. Events from 2010 to the present have cast doubt on the concept of “risk-free” as traditionally understood. Nevertheless, our example sticks with this traditional model in order to best explicate the concepts that we are discussing. “Carry trade” operations typically focus on these “risk-free” currencies because to use a currency with significant default risk and/or volatility introduces an element of uncertainty that is difficult, if not impossible, to isolate and hedge. Such operations would fall more properly under pure speculation than the traditional definition of a carry trade.

“Global macro” investing refers to an investment strategy that involves seeking out favorable trading opportunities across international geographies. Such investors are generally unrestricted in their choice of country or asset class and often seek “arbitrage” opportunities where they will short (sell) an unfavorable asset in a particular country and buy favorable assets in that or another country, with the expectation that one or both trades will move in the anticipated direction and earn a profit. It is variously estimated that perhaps 20% of the world’s $2 trillion total hedge fund assets (as of 2011) are deployed in global macro strategies. A significant portion of global macro investing involves the carry trade.

Our profit in this example will be in JPY. If we wanted to have our profit back in USD, we could convert it at the prevailing spot rate at maturity or, more likely, eliminate the USD/JPY risk by using a forward contract at the time we initiate the trade. The perceptive reader will note that we never “invested” our $2 billion USD at all as we borrowed JPY and converted it into TWD to purchase the TWD debt. Normally to borrow the JPY in the first place, we would need to have collateral “locked up” on deposit with our broker—this is where our $2 billion USD comes into play assuming our broker did not permit us any leverage.

Some caveats: We use the key bank rates as the interest rates in our example; naturally the interest rates on borrowing and investing in 30-day instruments will differ to some degree from these rates. Also, 30 days is at the long end of maturity for a carry trade, the majority of which involve continual rollover of overnight or very short-term transactions. To spare our reader from poring through 450 overnight transactions over 15 pages, we’ve simplified the example to 30-day borrowing and lending. The essential conclusions are no less valid using these streamlined assumptions.

Generational Dynamics, “Sudden Collapse of Iceland Króna Portends Bursting of "Carry Trade" Bubble,” February 27, 2006, accessed March 31, 2011, http://​www.​generationaldyna​mics.​com/​pg/​xct.​gd.​e060227.​htm

The aggregate size of the global carry trade is very difficult to estimate, as there is no standard for reporting from financial institutions. Some estimates have the total at 15–20 % of daily global foreign exchange transactions. At $4 trillion daily, this would imply $600 to $800 billion in carry trade activity. Source: “Regulators Tackle ‘Carry Trades,’” Dealbook, New York Times, February 11, 2010, 5:01am accessed April 4, 2011, http://​dealbook.​nytimes.​com/​2010/​02/​11/​regulators-tackle-carry-trades/​

In July 2008, at the peak of the subprime and financial crisis, the PBoC again locked the yuan tightly to the US$ at a rate of approximately 6.83 RMB to 1 USD and held it there until July 2010.