CURRENCY EXCHANGE RATES: DETERMINATION AND FORECASTING

CURRENCY EXCHANGE RATES: DETERMINATION AND FORECASTING

Currency Cross Rates
For example, given the USD/EUR and JPY/USD exchange rates, we can calculate the cross rate
between the JPY and the EUR, JPY/EUR as follows:
JPY
JPY
USD
=

EUR
USD EUR
Cross Rate Calculations with Bid-Ask Spreads
USD/EURask = 1.3806

USD/EURbid = 1.3802

Represents the price of EUR

An investor can buy EUR with
USD at this price.

Represents the price of EUR (base

currency).
An investor can sell EUR for USD
at this price (as it is the bid price
quoted by the dealer).
Determining the EUR/USDbid cross rate:
EUR/USDbid = 1/(USD/EURask)
Determining the EUR/USDask cross rate:
EUR/USDask = 1 / (USD/EURbid)
Forward exchange rates (F) - One year Horizom

FFC/DC = SFC/DC

(1 + iFC)
(1 + iDC)

FPC/BC = SPC/BC

Forward exchange rates (F) - Any Investment Horizom

FFC/DC = SFC/DC

1 + (iFC Actual 360)

1 + (iDC Actual 360)

FPC/BC = SPC/BC

1 + (iPC Actual 360)

1 + (iBC Actual 360)

Currencies Trading at a Forward Premium/Discount

FFC/DC - SFC/DC = SFC/DC

FPC/BC - SPC/BC = SPC/BC

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(
(

)
)

(iFC - iDC) Actual 360

1 + (iDC Actual 360)
(iPC - iBC) Actual 360
1 + (iBC Actual 360)

(1 + iPC)
(1 + iBC)

CURRENCY EXCHANGE RATES: DETERMINATION AND FORECASTING

Covered Interest Rate Parity

1 + (iPC Actual 360)

1 + (iBC Actual 360)

FPC/BC = SPC/BC

The forward premium (discount) on the base currency can be expressed as a percentage as:
FPC/BC - SPC/BC

Forward premium (discount) as a % =

SPC/BC

The forward premium (discount) on the base currency can be estimated as:
Forward premium (discount) as a % FPC/BC - SPC/BC iPC - iBC
Uncovered Interest Rate Parity
Expected future spot exchange rate:

SeFC/DC = SFC/DC

(1 + iFC)
(1 + iDC)

The expected percentage change in the spot exchange rate can be calculated as:
e

Expected % change in spot exchange rate = %DS PC/BC =

SePC/BC SPC/BC
SPC/BC

The expected percentage change in the spot exchange rate can be estimated as:
Expected % change in spot exchange rate %DSePC/BC iPC - iBC
Purchasing Power Parity (PPP)
Law of one price: PXFC = PXDC SFC/DC
Law of one price: PXPC = PXBC SPC/BC
Absolute Purchasing Power Parity (Absolute PPP)
SFC/DC = GPLFC / GPLDC
SPC/BC = GPLPC / GPLBC
Relative Purchasing Power Parity (Relative PPP)
Relative PPP: E(S

FC/DC)

= S

FC/DC

1 + pFC
1 + pDC

Ex Ante Version of PPP

Ex ante PPP: %DSeFC/DC peFC - peDC
Ex ante PPP: %DSePC/BC pePC - peBC

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CURRENCY EXCHANGE RATES: DETERMINATION AND FORECASTING

Real Exchange Rates

The real exchange rate (qFC/DC) equals the ratio of the domestic price level expressed in the foreign
currency to the foreign price level.
qFC/DC =

PDC in terms of FC
PFC

PDC SFC/DC
PFC

= SFC/DC

( )
PDC
PFC

The Fisher Effect

Fischer Effect: i = r + pe
International Fisher effect: (iFC iDC) = (peFC peDC)
Figure 1: Spot Exchange Rates, Forward Exchange Rates, and Interest Rates

Ex Ante PPP

Foreign-Domestic
Expected Inflation
Differential
peFC - peDC
International Fisher
Effect

Expected change
in
Spot Exchange Rate
%DSeFC/DC

Forward Rate as
an Unbiased
Predictor

Uncovered Interest
Rate Parity

Foreign-Domestic
Interest rate
Differential
iFC - iDC

Forward Discount
FFC/DC - SFC/DC
SFC/DC
Covered
Interest Rate
Parity

Balance of Payment
Current account + Capital account + Financial account = 0
Real Interest Rate Differentials, Capital Flows and the Exchange Rate
qL/H qL/H = (iH iL) (peH peL) (FH FL)

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CURRENCY EXCHANGE RATES: DETERMINATION AND FORECASTING

The Taylor rule

i = rn + p + a(p - p*) + b(y - y*)
where
i = the Taylor rule prescribed central bank policy rate
rn = the neutral real policy rate
p = the current inflation rate
p* = the central banks target inflation rate
y = the log of the current level of output
y* = the log of the economys potential/sustainable level of output
qPC/BC = qPC/BC + ( rnBC - rnPC) + a[(pBC - p*BC) - (pPC - p*PC)]
+ b[(yBC - y*BC) - (yPC - y*PC)] - (FBC - FPC)

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ECONOMIC GROWTH AND THE INVESTMENT DECISION

ECONOMIC GROWTH AND THE INVESTMENT DECISION

Relationship between economic growth and stock prices
P = GDP

( )( )
E
GDP

P
E

P = Aggregate price or value of earnings.

E = Aggregate earnings
This equation can also be expressed in terms of growth rates:
DP = D(GDP) + D(E/GDP) + D(P/E)
Production Function
Y = AKaL1-a
Y = Level of aggregate output in the economy
L = Quantity of labor
K = Quantity of capital
A = Total factor productivity. Total factor productivity (TFP) reflects the general level
of productivity or technology in the economy. TFP is a scale factor i.e., an increase
in TFP implies a proportionate increase in output for any combination of inputs.
a = Share of GDP paid out to capital
1 - a = Share of GDP paid out to labor
y = Y/L = A(K/L)a(L/L)1-a = Ak a
y = Y/L = Output per worker or labor productivity.
k = K/L = Capital per worker or capital-labor ratio
Cobb-Douglas production function
DY/Y =DA/A + aDK/K + (1 - a )DL/L
Potential GDP
Growth rate in potential GDP = Long-term growth rate of labor force
+ Long-term growth rate in labor productivity
Labor Supply
Total number of hours available for work = Labor force Average hours worked per worker

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ECONOMIC GROWTH AND THE INVESTMENT DECISION

Neoclassical Model (Solows Model)

( )[( )

Y
1
=
K
s

q
+d+n Y
(1-a)

s = Fraction of income that is saved

q = Growth rate of TFP
a = Elasticity of output with respect to capital
y = Y/L or income per worker
k = K/L or capital-labor ratio
d = Constant rate of depreciation on physical stock
n = Labor supply growth rate.
Savings/Investment Equation:

sy =

[( )

q
+d+n k
(1 - a)

Growth rates of Output Per Capita and the Capital-Labor Ratio

Dy
q
Y
=
+ as
-Y
y
(1-a)
K

( ) (

Dk
q
Y
+s
-Y
=
(1-a)
K
k

Production Function in the Endogenous Growth Model

ye = f(ke) = cke

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INVENTORIES: IMPLICATIONS FOR FINANCIAL STATEMENT AND RATIOS

INVENTORIES: IMPLICATIONS FOR FINANCIAL STATEMENTS AND RATIOS

Ending Inventory = Opening Inventory + Purchases - Cost of goods sold

LIFO and FIFO Comparison with Rising Prices and Stable Inventory Levels
LIFO

FIFO

COGS

Higher

Lower

Income before taxes

Lower

Higher

Income taxes

Lower

Higher

Net income

Lower

Higher

Total cash flow

Higher

Lower

EI

Lower

Higher

Working capital

Lower

Higher

LIFO versus FIFO with Rising Prices and Stable Inventory Levels
Type of Ratio
Profitability ratios
NP and GP margins

Solvency ratios
Debt-to-equity and
debt ratio
Liquidity ratios
Current ratio

Quick ratio

Activity ratios
Inventory turnover
Total asset turnover

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Effect on
Numerator

Effect on
Denominator

Income is lower
under LIFO because
COGS is higher

Sales are the same

under both

Lower under LIFO

Same debt levels

Lower equity and

assets under LIFO

Higher under LIFO

Current assets are

lower under LIFO
because EI is lower

Current liabilities are

the same.

Lower under LIFO

Quick assets are

higher under LIFO as
a result of lower taxes
paid

Current liabilities are

the same

Higher under LIFO

COGS is higher
under LIFO

Average inventory is
lower under LIFO

Higher under LIFO

Sales are the same

Lower total assets

under LIFO

Higher under LIFO

Effect on Ratio

INVENTORIES: IMPLICATIONS FOR FINANCIAL STATEMENT AND RATIOS

LIFO reserve (LR)

EIFIFO = EILIFO + LR
where LR = LIFO Reserve
COGSFIFO is lower than COGSLIFO during periods of rising prices:
COGSFIFO = COGSLIFO - (Change in LR during the year)
Net Income after tax under FIFO will be greater than LIFO net income after tax by:

Change in LIFO Reserve (1 - Tax rate)

When converting from LIFO to FIFO assuming rising prices:
Equity (retained earnings) increases by:
LIFO Reserve (1 - Tax rate)
Liabilities (deferred taxes) increase by:
LIFO Reserve (Tax rate)
Current assets (inventory) increase by:
LIFO Reserve

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