Foreign exchange rates are extremely volatile and understanding what influences exchange rates plays a big part in developing your strategy.
Foreign exchange movements are important considerations if we want to protect (or boost returns on) our global investments. Fundamentally, exchange rates do not move without reason.
Interest Rate Parity
Under a condition known as interest rate parity, exchange rates move in response to the difference in interest rates between two countries.
Suppose we can choose to invest in 2 countries at their prevailing 1-year interest rates – US at 5% or Singapore at 2%.
For the sake of simplicity, we assume that the current exchange rate (also known as the spot rate) between SGD and USD is SGD1:USD1. At the end of 1 year,
This implies that in 1 year’s time, the exchange rate between SGD and USD would be SGD1: USD1.03 (US$105/S$102).
Note that the US, which has higher interest rates than SG, have depreciated by an amount roughly equivalent to the difference in interest rates.
Other Factors Affecting Exchange Rates
Interest rate differentials can change overnight when governments change their monetary policies. Interest rate expectations are also influenced by expected economic growth rates, which are affected by changes in economic policies of the governments.
The potential pool of factors that may affect exchange rate movements is large and contains both economic and non-economic variables, as well as trends in time series. Exchange rate predictions of such scale will require the use of mathematical models and computational power.
Interest rate parity is a very strong condition that underpins forward rates in exchange rate markets. A forward rate contract is an instrument that obliges you to execute a foreign exchange transaction in the future at a price determined today.
In the above example, the 1-year forward rate for USD–SGD, as determined by the interest rate parity, is SGD1:USD1.03.
If any financial institutions quote a different rate, for example SGD1:USD1.02, then investors can earn risk-less profits in 3 simple steps:
Step 1: Exchanging SGD for USD at the spot rate of SGD1:USD1
Step 2: Investing in the USD at a 5% interest rate
Step 3: Fulfilling the forward contract by buying SGD at a cheaper USD rate than implied by the interest rate differential.
The ease and simplicity of the interest rate parity strategy keep foreign exchange rates efficient, as any mispricing can be quickly exploited.
In addition, exchange rates quoted by various financial institutions are typically comparable to one another. All of them are simultaneously buying and selling to profit from a difference in the price, and this practice is known as arbitraging.
Here are 2 examples of arbitraging activities:
Find a bank with a better rate
If Bank A is willing to buy USD at a higher rate than Bank B is selling it, then investors can make riskless profits by buying USD from Bank B and selling to Bank A.
In a triangular arbitrage – exchanging the initial currency for a 2nd, the 2nd currency for a 3rd, and the 3rd currency for the initial – investors can
The forward rate is however not a perfect predictor of the actual exchange rate in the future. This is because the exchange rate expectations change whenever new information about the countries involved are revealed to the market, similar to how the price of a stock reacts to new information about the company.
Using the same example as above, a currency carry trade involves borrowing the currency with the lower interest rate (SGD) at 2%, converting into the currency with the higher interest rate (USD), and investing in USD bonds at 5%.
Interest rate parity predicts that USD will devalue over time, but market sentiments and momentum may cause the USD to appreciate over a short period of time. In this case, we profit from both the interest rate differential and currency appreciation.
Forecasting exchange rates for speculative purposes is a difficult task which requires you to be “glued to the screen”. Intensive monitoring efforts, a strong understanding of economic fundamentals, as well as quick execution abilities are needed for success.
As such, most participants in the currency market simply use forex instruments as hedging tools to neutralise exchange rate risks by “locking in” a future exchange rate today.