Capital Market Expectations: FX

CFA Level III Portfolio Management
#1

Hi, I have a question on the practice quiz below about capital market expectations in foreign rates.

According to PPP (using information on inflation rates) and Uncovered Interest Rates Parity (using Bond yield data), I think the answer is B.
But I don’t know how the other information work. Please advise.

Thank you in advance!

Rosa Cochrane, CFA, an analyst at an investment fund, is evaluating the currency risk in her portfolio. Cochrane has gathered macroeconomics data on Country A, a small developing economy, and Country B, a large developed economy.
The exports of Country A are commodity products with multiple substitutes from other countries while its imports are relatively inelastic.
Cochrane expects the world economy to enter a severe recession in the coming year. Until last year Country A had pegged its currency to the currency of Country B.

Country------------% of GDP from Exports------------Inflation Rate------------Bond Yield
Country A --------- 40% ------------ 4% ------------ 8%
Country B --------- 10% ------------ 2% ------------ 4%

Relative to the currency of Country B, Cochrane would most likely expect the currency of Country A to:

A. Appreciate
B. Depreciate
C. Stay the same

#2

You are correct in your answer above. Use the interest rate parity formula for an example:

Currency A/B spot exchange rate is 1.2 units of currency A for each unit of currency B (just pick a number).
The projected currency A/B forward rate is: 1.2(1.08/1.04) = 1.246 units of currency A for each unit of currency B. So currency A is expected to depreciate versus B and currency B is expected to appreciate versus A. If currency A was still pegged to currency B, there would be a carry trade opportunity to potentially exploit by the way.

Also everything they described in the problem implied a future weakness in currency A. It’s a small export-driven economy with many substitutes for its exports, facing a severe global recession… nothing bullish to that fact pattern. And the inflation of country A is happening at a faster rate than in country B, as you already indicated in your analysis.

Cheers you got this👍

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#3

Thank you for the comment again. It’s clear now.

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