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BMC-module-2-2-notes-currency.txt
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2:04 PM 8/20/2024
BMC Module 2.2: Currency Valuation Drivers
Currency exchange rates
Currency arbitrage (no longer possible, at least not to the extent that it previously was)
Can be possible in periods of high volatility, but this comes with different risks,
whereas arbitrage opportunies under normal conditions are risk-free profit
In theory, currencies should eventually adjust in value against each other so that:
a basket of goods and services priced in one currency should cost the same
as when they are priced in another currency
this is known as purchasing power parity (PPP)
PPP is a better measure of long term trends than short-term ones [why?]
e.g. Big Mac Index
Primary methods for analyzing currency movement:
- macroeconomics
- sentiment analysis
Core assumptions of fundamental analysis
- all information is available to all investors simultaneously
- all investors seek to maximize their returns whilst minimizing their risk
- all investors act with complete rationality at all times
None of these assumptions are correct in practice.
Sentiment analysis assumes that human investors are incapable of maintaining maximum
efficiency+rationality, and instead have behavioral weaknesses that impact trading decisions
----
Some macroeconomic indicators that are relevant for currency investors:
- GDP
- CPI
- unemployment
- industrial production
- business conditions
- retail sales
- current account balance (as % of gdp) [??]
- budget balance (as % of gdp)
- 10Y yield
- central bank rate [?]
-> Bloomberg WCRS -> 290) Economics:
- Inflation
- Growth
- Interest rates [aka yield]
- Current account surplus/deficit [?]
----
Inflation -> direct affect on currency exchange rates
Growth -> increased demand for goods/services in that country -> likely appreciation of currency
Interest rates -> related to inflation+growth, and have direct impact on currency flows
"yield differential": difference between interest rates in two currencies
these yield differentials are closely watched by currency investors
Investors also watch for bond yield differentials:
e.g the difference in yields on 10 year govt bonds in different countries
note that such analysis of currency markets differs from that of equity/FI markets
equity and FI investors consider also the underlying corporate issuer
[???]
currency investors consider the ability of the govt to deliver policies
which will maintain the value of the currency via low inflation
whilst generating sufficient growth to maintain demand for
assets denominated in that currency
https://en.wikipedia.org/wiki/Bulgarian_lev
Bulgaria will join the Eurozone as soon as a price stability criterion is met
Right now, the Bulgarian Lev (BGN) is fixed to the Euro at BGN 1.96 : EUR 1
------
The Fed has a dual mandate: stable inflation and low unemployment
The main tool that the fed has is raising/lowering interest rates
Typically, raising interest rates will curb inflation
Typically, lowering interest rates will raise employment [why?]
[this takes a long time]
-----------
Bloomberg currency commands: first is priced in terms of the second, e.g. CHFUSD CURNCY
Three main drivers of currency valuation:
1. Surprise changes in interest rates
2. Surprise changes in inflation
3. Surprise changes in trade