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What drives the currency

markets?

By

A.V. Vedpuriswar

Feb 10, 2008

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Acknowledgment

This presentation draws heavily from Investopedia.com

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The five factors

In order of importance, they are:

Interest Rates

Economic GrowthGeo-Politics

Trade and Capital Flows

Merger and Acquisition Activity

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GEN0190n.ppt 20

Problem - 1

3 month interest rates were quoting as follows on

January 19th

, 2008:

Dollar - 3.74%

Yen - 0.74%

Sterling - 5.58%

The exchange rates quoted in the market were asfollows:

Yen 121/ $ .51/$

What should the three month forward rates be toprevent arbitrage?

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Solution

/$5123.

0094.1

01395.1.51

/$)4/0374.1(

.0558/4)(1.51

rateExchange

.0558/4)(1.51)4

0374.1($

$/09.120

0094.1

)00185.1(121

)4

0074.1(121)4

0374.1(1$

Yen

rateExchange

Yen

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Problem - 2

Inflation in the US is currently 4.1%, that in Japan,0.6% and in Britain, 2.1%. The current exchange ratesare Yen 121/$, .51/$. What will be the exchange rate

after one year if purchasing power parity holds?

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.50/$

/$)041.1(1

)021.1(51.rateExchange

.021).51(1)041.1(1$

$/93.116$/)041.1(1

)006.1(121

)041.1(1$)006.1(121

YenYenrateExchange

Yen

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Problem - 3

The rates currently quoted are Yen 120/$. .50/$ and

Yen 220/ . Is there any scope for triangular arbitrage.

Borrow Yen 220

Sell for 1

Sell 1 to get $ 2

Sell $ 2 to get Yen 240

Profit = Yen 20

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Problem - 4

A Japanese importer needs $1,320,000 a year from

now. The current rate is Yen 120/$. How can theexporter hedge the risk in the money market. If the 1year $ interest is 10%?

$ needed 1 year from now = $ 1,320,000

$ needed to be invested today = $ 1,320,000/1.1

= $ 1,200,000

Yen needed today = Y 144,000,000

Borrow Yen 144,000,000 convert into $, invest for ayear.

The payable exposure is fully hedged.

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Problem - 5

3 Month Dollar interest rate - 2.5%

3 Month Sterling interest rate - 5.0%

The spot exchange rate is /$ .51 / .53

What should be the 3 month forward rate to preventarbitrage?

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GEN0190n.ppt 27

Solution Borrow $ 100

Convert into . We get 51

Invest 51 for 3 months. We get 51 (1+.05/4)

Convert into $. We get 51 (1+.05/4)/F = 51.64/F

For no arbitrage, 100 51.64/F

Or F .5164

Borrow 100

Convert into $. We get $ 100/.53

Invest for 3 months. We get $100/.53 (1+.025/4) = 189.86 Convert back into sterlings. We get 189.86F

For arbitrage, 100 189.86 F

Or F 100/189.86 = .5267

So for no arbitrage, F .5164 and F .5267