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Fin 444 Assignment 2

Jubayer Rahman 081-600-030Muhammad Moinuddin 091 0995 030Abid Mustafizur Rahman 073 -428-030Asma Quadry Deepa 072 -294-030 Tasnim Fhamida Iqbal 071-303-030 Prepared for:Mirza M. Ferdous(MzF)

Definitions:

Government Intervention in Foreign Exchange MarketForeign exchange intervention is defined generally as foreign exchange transactions conducted by the monetary authorities (Central Bank) with the aim of influencing exchange rates. It is the process by which the monetary authorities attempt to influence market conditions and/or the value of the home currency on the foreign exchange market. Intervention usually aims to promote stability by opposing disorderly markets, or in response to special circumstances. Central Banks engage in international transactions by buying foreign denominated assets and selling their currency or by selling foreign assets (from their international reserves) and purchasing the domestic currency. These activities affect the exchange rate of the home currency with respected currencies.Interest Rate Parity (IRP)This theory quantifies the relationship between interest rate differential and forward rate (discount or premium). This theory says that when the difference between the interest rates of two countries and the difference between the forward and spot rates of those countries is same, then interest rate parity holds. Market forces cause the forward rate to differ from the spot rate by an amount that is sufficient to offset the interest rate differential between the two currencies. Then, covered interest arbitrage is no longer feasible, and the equilibrium state achieved is referred to as interest rate parity (IRP).When IRP exists, the rate of return achieved from covered interest arbitrage should equal the rate of return available in the home country.Purchasing Power Parity (PPP)This theory tries to quantify the relationship between inflation and exchange rates. When one countrys inflation rate rises relative to that of another country, decreased exports and increased imports depress the countrys currency.

There are two types of PPP:1. Absolute form of PPP: The absolute form of PPP, or the law of one price, suggests that similar products in different countries should be equally priced when measured in the same currency.1. Relative form of PPP: The relative form of PPP accounts for market imperfections like transportation costs, tariffs, and quotas. It states that the rate of price changes should be similar.International Fisher Effect (IFE)International Fisher Effect (IFE) Theory states that the currency of a nation with a comparatively higher interest rate will depreciate in value in comparison to the currency of a nation with a comparatively lower interest rate. It further implies that the extent of depreciation will be equal to the difference in interest rates in those two nations. It is based on the observation that the level of real interest rate in an economy is closely linked to the level of local inflation rate and is independent of a government's monetary policies. Thus, in general, the higher the inflation rate, the lower the value of currency. According to IFE if the interest rate in foreign country increases, then the currency of that country will depreciate as increase in nominal interest rates reflect expected inflation.

BDT against USDThe Bangladeshi Taka (BDT) exchange rate depreciated 8.35 % against the US Dollar (USD) during the last 12 months, considering from the very start of the year 2010. Historically, from 1994 until 2011 the USD and BDT exchange averaged 72.05 reaching an historical high of 78.60 in November of 2011 and a record low of 40.10 in June of 1995. The Bangladeshi Taka spot exchange rate specifies how much one currency, the USD, is currently worth in terms of the other, the BDT.

As we can see in the graph above that from the year 2007 till the end of 2009 the exchange rate between BDT and USD was pretty much stable with little unnoticeable fluctuations around 68 Taka per Dollar to 69 Taka per Dollar. But, from the beginning of the year 2010 the exchange rate of BDT with USD was towards an increasing trend, starting from 68.80 Taka per Dollar to being 78.60 Taka per Dollar as of Today November 25, 2011.Exchange rate management is one of the central issues and Exchange rate of Bangladesh has received wide attention among all concerned from end-May, 2003 when Bangladesh adopted the floating exchange rate system. Traditionally, Bangladesh had been maintaining various pegged exchange rate regimes, such as pegged to the British pound sterling (1972-1979), pegged to a basket of major trading partners' currencies with pound sterling as the intervening currency (1980-1982), pegged to a basket of major trading partners' currencies with US dollar as the intervening currency (1983-1999), and an adjustable pegged system (2000-2003). On May 31, 2003, Bangladesh switched to floating exchange rate system by abandoning the adjustable pegged system. Bangladesh maintains a floating exchange rate system from the year 2003 and empirical evidence and theory suggests that floating exchange rates are characterized by little intervention in the exchange rate markets together with unlimited volatility of the nominal exchange rate. In a floating system, since little or no intervention is required, reserves exhibits relatively low volatility. However, it is observed that relative volatilities of the exchange rate, reserves and interest rates are very low for the period 2007 - 2009, indicating an active intervention in the foreign exchange market by the Government of Bangladesh. This observation is correct because Bangladesh Bank purchased US $1.48 billion from the inter-bank market in 2008 2009. Such foreign exchange intervention activities have led to a situation where the nominal exchange rate has remained almost fixed or has moved within a very narrow range for the aforesaid period.Therefore, the exchange rate system of Bangladesh has not been in the pure state of the freely floating rate system. All in all, Bangladesh practices a managed floating rate system from the very beginning of its transition to floating system as the government of Bangladesh intervenes when the currency in moving more of one side. However, to manage floats or to maintain a long-term value of the currency, Bangladesh Bank must have to acquire a good stock of international reserves.In addition to all these, the recent exchange rate hike (2010 Jan to now Nov 2011) of USD against BDT is the main concern for Bangladesh and the Finance Minister of Bangladesh, Abul Maal Abdul Muhith states that the reason for this is because the Bangladesh Bank tried to lock the price of USD at Taka 69, which was wrong and therefore the price of dollar has been steadily rising against the taka. As a result, the reserve is under pressure in line with the importing cost and also the other reason is the Hajj as because those who went to perform Hajj, they had to take dollars with them which worsened the exchange rate as the demand for USD increased against BDT.Over the longer term, the most important policy for preserving the value of the Bangladeshi currency is to keep inflation under control. If the inflation rate in Bangladesh continues to be substantially higher than the US inflation rate, demand for dollar will continue to exceed its supply and the price of the dollar in taka terms will continue to rise over the long term.

Interest and Inflation Rates in Bangladesh for the past 5 Years

Interest RateYearLending rateDeposit rate

200611.06%5.77%

200712.28%6.51%

200812.63%7.23%

200913.36%7.97%

201012.75%7.34%

Inflation RateYearRate %Real GDP %

20057%6.4%

20067.2%6.65

20079.1%6.3%

20088.9%4.9%

20095.4%4.7%

20108.1%6%

By looking at the tables above we can say that the interest rates and inflations rates in Bangladesh have fluctuated a lot over the past five years. In the year 2006 the lending rate and the deposit rate were low compared to that of the other 4 years. The lending rate and deposit rate increased on 2007, this might have been because of changes in policies made by government as these policies of government effect interest rates and that in turn affects the inflation rates. In 2006, there was an increase in money supply and because of which general public were holding more money. Government might have wanted to control this situation and might have wanted to control the money supply of Bangladesh and so might have implemented contradictory monetary policy. By this policy, government of Bangladesh decreased the money supply, though there was high demand for money. As a result of this mismatch the interest rates have increased in 2007. Lending rate increased to 12.28% and deposit rate increased to 6.51%. This indicates that in 2007, investors were discouraged to invest due to increase in lending rates and on the other hand, depositors were encouraged to deposit which was also due to increase in deposit rates. As investors were discouraged to invest, investments in that year decreased which affected the income levels of the people of the country. Income levels decreased as investments decreased, decreasing production and increasing unemployment. This all lead to increase in price level, and that increased the inflation rate in 2007 by a large amount, it rose to 9.1% which is a lot compared to the last years. As inflation rate rose by a huge amount, this increased the general price level of commodities in Bangladesh, which affected the international trading as well. Increase in prices decreased exports, increased imports. People were buying imported goods as those were cheaper compared to local goods. All these had combined effect in the GDP of our country; it decreased to 6.3% from 6.65% in the last year. In the year 2008, the lending rate and the deposit rates increased further which again decreased investments and increased savings. As investments decreased this decreased the income levels as well, though inflation decreased but it did not decrease by a significant amount, as a result GDP continued to decrease and became 4.9% which indicates a significant amount of drop from 6.3% in 2007. In 2009, the interest rates increased the most; lending rate became 13.36% and deposit rate increased to 7.97% again indicating decrease in investments and increase in savings. Again in this year inflation decreased but that did not lead to an increase in our GDP. This decrease in GDP indicated that people were becoming more and more dependent on imported commodities rather than domestic commodities. In 2010, some changes took place again, a decrease in interest rates were seen. This might have been the result of changes in the policies of government. This time maybe the government of Bangladesh wanted to increase the money supply, which will increase investments and that might bring up the GDP rate. As the GDP was continuously decreasing, government might have wanted to improve the overall situation of the country. This time government might have implemented expansionary monetary policy which increases money supply and decreases interest rates. So in 2010, lending rate decreased to 12.75% and deposit rate decreased to 7.34%, this shows that people then wanted to invest as the interest rates decreased a little bit and as the deposit rates decreased depositors were discouraged to save money. They wanted to invest rather than save as that would have earned them more return. As investments increased, production increased, employment opportunities were created as a result unemployment reduced increasing employment rate. This all had an effect in the level of income, as investments were being made, employment increased, so level of income also increased. Though in 2010, inflation also increased to 8.1%, but this did not affect the GDP of Bangladesh that much as it increased to 6% which was quite good compared to the last years. This might have happen because of increase in investments, increase in consumptions, decrease in savings, increase in income level, and decrease in dependence on foreign commodities, decrease in imports. So from the above data, we can conclude that, government policies affect interest rates as interest rates depend heavily on government policies and these interest rates make an impact on inflation rates, income level and to the GDP of a country.

IRP, PPP, and IFE in context of BDT against USD

Interest Rate Parity (IRP)Derivation of IRP:End-value of a $1 investment in covered interest arbitrage = (1/S) (1+iF) F = (1/S) (1+iF) [S (1+p)] = (1+iF) (1+p)In which, p is considered as the forward premium.

End-value of a $1 investment in the home country= 1 + iH

Equating the two and rearranging terms:p = (1+iH) -1 (1+iF)

Forward = (1 + home interest rate) - 1Premium (1 + foreign interest rate)

When IRP is calculated certain factors are taken into considerations. They are:1. Political Risks: Governments might bring some changes in terms of exchange in currencies.1. Different tax laws: Different countries have different laws, when laws vary, after tax returns should be considered rather than before tax returns.

Purchasing Power Parity (PPP)Derivation of PPP:Assumehome countrys price index (Ph) = foreign countrys price index (Pf)When inflation occurs, the exchange rate will adjust to maintain PPP:Pf (1 + If ) (1 + ef ) = Ph (1 + Ih )Where,Ih=inflation rate in the home countryIf=inflation rate in the foreign countryef=% change in the value of the foreign currency Since Ph = Pf and solving for ef gives:ef=(1 + Ih) 1(1 + If)If Ih>If ,ef> 0 (foreign currency appreciates)If Ihif ,ef> 0 (foreign currency appreciates)If ih