Page 13 - FINAL CFA II SLIDES JUNE 2019 DAY 4

LOS 11.g: Evaluate the use of the current spot rate, the forward
rate, purchasing power parity, and uncovered interest parity to READING 11: CURRENCY EXCHANGE RATES: UNDERSTANDING EQUILIBRIUM VALUE
forecast future spot exchange rates.
MODULE 11.2: MARK-TO-MARKET VALUE, AND PARITY CONDITIONS
LOS 11.h: Explain approaches to assessing the long-run fair
value of an exchange rate.

We can use ex-ante PPP, uncovered interest rate parity, or forward rates to forecast future spot rates.

UCIRP and PPP are not bound by arbitrage and seldom work over the short and medium terms.

If relative PPP holds at any point in time, the real exchange rate (i.e., the exchange rate adjusted for relative historical inflation between the
currency pair) would be constant.

However, since relative PPP seldom holds over the short term, the real exchange rate fluctuates around its mean-reverting equilibrium value.

The international Fisher effect (and real rate parity) assumes that there are no differences between sovereign risk premia, but we know
investors do demand a higher real rate of return (i.e., a risk premium) for investing in emerging market!

LOS 11.i: Describe the carry trade and its relation to uncovered interest rate parity and calculate the profit from a carry trade.

FX Carry Trade: Recall UIRP is not bound by arbitrage: given this, FX Carry Trade occurs if say GBP depreciates by < 2% (or even
appreciates), and investor takes a position in higher yielding GBP using borrowed USD (the funding currency), earning excess profits.

FX carry trade attempts to capture IRD, betting against UCIRP. They typically perform well during low-
volatility periods. Sometimes, higher yields attract larger capital flows, which in turn lead to an
economic boom and appreciation (instead of depreciation) of the higher yielding currency.
This could make the carry trade even more profitable, because the investor earns a return from
currency appreciation in addition to the return from the interest rate spread. The risk?
Risks of the Carry Trade:
Compute the profit to an investor borrowing in the US & investing in the UK 1. The funding currency may appreciate against the currency of the investment, reducing profit—or
even lead to a loss.
2. The return distribution of the carry trade is not normal (it has -ve skewness and excess kurtosis
(i.e., fat tails): probability of a large loss (crash risk of the trade) is higher. Crash risk stems from
the carry trade’s leveraged nature - as more investors adopt the same strategy, the demand for
high-yielding currency actually pushes its value up.
However, with this herding behavior comes the risk that all investors may attempt to
exit the trade at the same time (say all use stop-loss orders in their carry trades.)
During turbulent times, as investors exit their positions (i.e., a flight to safety), the
high-yielding currency can experience a steep decline in value, generating large
losses for traders pursuing FX carry trades.