Question

How does a decrease in U.S. interest rates affect the EU/U.S. exchange rate? Use the carry trade to predict the impact of lower U.S. interest rates on Euro/$.

Answer 1

The exchange rate is simply the price of one country's currency expressed in another country's currency. In other words, the rate at which one currency can be exchanged for another. For example, the exchange rate between the U.S. dollar and the Japanese yen is US$1 = 104 yen, the rate at which you could exchange (sell) your dollars for Japanese yen is 1:104 (i.e., for each dollar you exchange, you receive 104 yen). Likewise the exchange rate between the dollar and the euro is US$1 = 0.75 euro (i.e., for each dollar you exchange, you receive 0.75 euro). It should be noted that these exchange rates change on a daily basis; therefore, the rates used here are only for illustrative purposes. The actual rates can be found online at the Federal Reserve Board's website(http://www.federalreserve.gov/releases/G5/current/default.htm).

The exchange rate is important because it allows for the conversion of one country's currency into that of another, thereby facilitating international trade for purchases of goods and services and/or transfer of funds between countries, and it allows price comparison of similar goods in different countries. In general, the price difference between similar goods determines which goods are traded and where they are shipped or sourced. Hence, the exchange rate is a significant factor influencing the competitiveness of agricultural commodities and the profitability of farming enterprises.

Answer 2

P	QS	QD	Profit=TR-TC	Note: Calculate the profit at the equilibrium
25	3250	3500	31687.5
26	3250
27	3250
28	3250
29	3250
30	3250
31	3250
32	3250
33	3250
34	3250
35	3250
36	3250
37	3250
38	3250
39	3250
40	3250
41	3250
42	3250
43	3250
44	3250
45	3250
46	3250
47	3250
48	3250
49	3250
50	3250

Answer 3

The global markets are really just one big interconnected web. We frequently see the prices of commodities and futures impact the movements of currencies, and vice versa. The same is true with the relationship between currencies and bond spread (the difference between countries\' interest rates): the price of currencies can impact the monetary policy decisions of central banks around the world, but monetary policy decisions and interest rates can also dictate the price action of currencies. For instance, a stronger currency helps to hold downinflation, while a weaker currency will boost inflation. Central banks take advantage of this relationship as an indirect means to effectively manage their respective countries\' monetary policies.

By understanding and observing these relationships and their patterns, investors have a window into the currency market, and thereby a means to predict and capitalize on the movements of currencies.

What Does Interest Have to Do With Currencies?
To see how interest rates have played a role in dictating currency, we can look to the recent past. After the burst of the tech bubble in 2000, traders went from seeking the highest possible returns to focusing on capital preservation. But since the U.S. was offering interest rates below 2% (and going even lower), many hedge funds and those who had access to the international markets went abroad in search of higher yields. Australia, with the same risk factor as the U.S., offered interest rates in excess of 5%. As such, it attracted large streams of investment money into the country and, in turn, assets denominated in the Australian dollar.

These large differences in interest rates led to the emergence of the carry trade, an interest rate arbitrage strategy that takes advantage of the interest rate differentials between two major economies, while aiming to benefit from the general direction or trend of the currency pair. This trade involves buying one currency and funding it with another, and the most commonly used currencies to fund carry trades are the Japanese yen and the Swiss franc because of their countries\' exceptionally low interest rates. The popularity of the carry trade is one of the main reasons for the strength seen in pairs such as the Australian dollar and the Japanese yen (AUD/JPY), the Australian dollar and the U.S. dollar (AUD/USD), the New Zealand dollar and the U.S. dollar (NZD/USD), and the U.S. dollar and the Canadian dollar (USD/CAD). (Learn more about the carry trade in The Credit Crisis And The Carry Trade and Currency Carry Trades Deliver.)

However, it is difficult for individual investors to send money back and forth between bank accounts around the world. The retail spread on exchange rates can offset any additional yield they are seeking. On the other hand, investment banks, hedge funds, institutional investors and large commodity trading advisors(CTAs) generally have the ability to access these global markets and the clout to command low spreads. As a result, they shift money back and forth in search of the highest yields with the lowest sovereign risk (or risk of default). When it comes to the bottom line, exchange rates move based upon changes in money flows.

The Insight for Investors
Individual investors can take advantage of these shifts in flows by monitoring yield spreads and the expectations for changes in interest rates that may be embedded in those yield spreads. The following chart is just one example of the strong relationship between interest rate differentials and the price of a currency.

AUD-USD 5YR Yields v AUDUSD 0.85 T 0.80 t 0.75 0.70 0.65 0.60 0.55 0.50 0.45- T 7.0 _IntRate Diff 6.0 45.0 4.0 3.0 2.0 1.0 0.0 ーAUDUSD Figure 1

Notice how the blips on the charts are near-perfect mirror images. The chart shows us that the five-year yield spread between the Australian dollar and the U.S. dollar (represented by the blue line) was declining between 1989 and 1998. This coincided with a broad sell-off of the Australian dollar against the U.S. dollar.

When the yield spread began to rise once again in the summer of 2000, the Australian dollar responded with a similar rise a few months later. The 2.5% spread advantage of the Australian dollar over the U.S. dollar over the next three years equated to a 37% rise in the AUD/USD. Those traders who managed to get into this trade not only enjoyed the sizable capital appreciation, but also earned the annualized interest rate differential. Therefore, based on the relationship demonstrated above, if the interest rate differential between Australia and the U.S. continued to narrow (as expected) from the last date shown on the chart, the AUD/USD would eventually fall as well. (Learn more in A Forex Trader\'s View Of The Aussie/Gold Relationship.)

This connection between interest rate differentials and currency rates is not unique to the AUD/USD; the same sort of pattern can be seen in USD/CAD, NZD/USD and the GBP/USD. Take a look at the next example of the interest rate differential of New Zealand and U.S. five-year bonds versus the NZD/USD.

NZDUSD 5YR Yields v NZDUSD 0.75 0.70 0.65 0.60 0.55 0.50 0.45 0.40 0.35 3.5 3.0 2.5 2.0 1.5 NZDUSD IntDiff 0.5 0.0 Figure 2

The chart provides an even better example of bond spreads as a leading indicator. The differential bottomed out in the spring of 1999, while the NZD/USD did not bottom out until the fall of 2000. By the same token, the yield spread began to rise in the summer of 2000, but the NZD/USD began rising in the early fall of 2001. The yield spread topping out in the summer of 2002 may be significant into the future beyond the chart. History shows that the movement in interest rate difference between New Zealand and the U.S. is eventually mirrored by the currency pair. If the yield spread between New Zealand and the U.S. continued to fall, then one could expect the NZD/USD to hit its top as well.

Other Factors of Assessment
The spreads of both the five- and 10-year bond yields can be used to gauge currencies. The genereal rule is that when the yield spread widens in favor of a certain currency, that currency will appreciate against other currencies. But, remember, currency movements are impacted not only by actual interest rate changes but also by the shift in economic assessment or plans by a central bank to raise or lower interest rates. The chart below exemplifies this point.

Economic Assessment and the Federal Funds Rate: Effects on the Dollar 130 8.00 7.00 120 6.00 110 5.00 100 -+--. Dollar Valu 4.00 Federal Funds Rate 90 3.00 Economic Assessment 80 2.00 Tightening 70 1.00 Easing Neutral Fears of 60 0.00 Deflation Figure 3

According to what we can observe in the chart, shifts in the economic assessment of the Federal Reserve tend to lead to sharp movements in the U.S. dollar. The chart indicates that in 1998, when the Fed shifted from an outlook of economic tightening (meaning the Fed intended to raise rates) to a neutral outlook, the dollar fell even before the Fed moved on rates (note on Jul 5, 1998, the blue line plummets before the red one). The same kind of movement of the dollar is seen when the Fed moved from a neutral to a tightening bias in late 1999, and again when it moved to an easier monetary policy in 2001. In fact, once the Fed just began considering lowering rates, the dollar reacted with a sharp sell-off. If this relationship continued to hold into the future, investors might expect a bit more room for the dollar to rally.

When Using Interest Rates to Predict Currencies Will Not Work
Despite the tremendous amount of scenarios in which this strategy for forecasting currency movements does work, it is certainly not the Holy Grail to making money in the currency markets. There are a number of scenarios in which this strategy may fail:

• Impatience
  As indicated in the examples above, these relationships foster a long-term strategy. The bottoming out of currencies may not occur until a year after interest rate differentials may have bottomed out. If a trader cannot commit to a time horizon of a minimum of six to 12 months, the success of this strategy may decrease significantly. The reason? Currency valuations reflect economic fundamentals over time. There are frequently temporary imbalances between a currency pair that can fog up the true underlying fundamentals between those countries.
• Too Much Leverage
  Traders using too much leverage may also not be suited to the broadness of this strategy. Since interest rate differentials tend to be fairly small, traders accustomed to using leverage may want to use it to increase. For example, if a trader used 10 times leverage on a yield differential of 2%, it would turn 2% into 20%, and many companies offer up to 100 times leverage, tempting traders to take a higher risk and attempt to turn 2% into 200%. However, leverage comes with risk, and the application of too much leverage can prematurely kick an investor out of a long-term trade because he or she will not be able to weather short-term fluctuations in the market.
• Equities Become More Attractive
  The key to the success of yield-seeking trades in the years since the tech bubble burst was the lack of attractive equity market returns. There was a period in early 2004 when the Japanese yen was soaring despite a zero-interest policy. The reason was that the equity market was rallying, and the promise of higher returns attracted many underweighted funds. Most large players cut off exposure to Japan over the previous 10 years because the country faced a long period of stagnation and offered zero interest rates. Yet, when the economy showed signs of rebounding and the equity market began to rally once again, money poured back into Japan regardless of the country\'s continued zero-interest policy. This demonstrates how the role of equities in the capital flow picture could reduce the success of bond yields forecasting currency movements.
• Risk Environment
  Risk aversion is an important driver of forex markets. Currency trades based on yields tend to be most successful in a risk-seeking environment and least successful in a risk-averse environment. That is, in risk-seeking environments, investors tend to reshuffle their portfolios and sell low-risk/high-value assets and buy higher-risk/low-value assets. Riskier currencies - those with large current account deficits (which you can learn more about here) - are forced to offer a higher interest rate to compensate investors for the risk of a depreciation that is sharper than the one predicted by uncovered interest rate parity. The higher yield is an investor\'s payment for taking this risk.

  However, in times when investors are more risk averse, the riskier currencies - on which carry trades rely for their returns - tend to depreciate. Typically, riskier currencies have current account deficits and, as the appetite for risk wanes, investors retreat to the safety of their home markets, making these deficits harder to fund. It makes sense to unwind carry trades in times of rising risk aversion, since adverse currency moves tend to at least partly offset the interest rate advantage.

  Many investment banks have developed measures of early warning signals for rising risk aversion. This includes monitoring emerging-market bond spreads, swap spreads, high-yield spreads, forex volatilities and equity-market volatilities. Tighter bond, swap and high-yield spreads are risk-seeking indicators while lower forex and equity-market volatilities indicate risk aversion.

Conclusion
Although there may be risks to using bond spreads to forecast currency movements, proper diversification and close attention to the risk environment will improve returns. This strategy has worked for many years and can still work, but determining which currencies are the emerging high-yielders versus which currencies are the emerging low-yielders may shift with time.

Answer 4

• Currency exchange rates are determined everyday in large global currency exchange markets. There is no fixed value for any of the major currency -- all currency values are described in relation to another currency. The relationship between interest rates, and other domestic monetary policies, and currency exchange rates is complex, but at the core it is all about supply and demand.

• Interest rates influence the return or yield on bonds. Because, for example, U.S. Treasury bonds can only be bought in U.S. dollars, a high interest rate in the U.S. will create demand for dollars in which to purchase those bonds. A low interest rate, relative to other major economies, will reduce demand for dollars, as investors move toward higher yielding investments. At least, this is true in normal periods of economic expansion.
  The relationship becomes a bit inverted, however, when investors become highly risk averse. In periods of credit contraction or recession, money will tend to move into safer assets, driving down interest rates. The low yield on bonds then is a reflection of the demand for their relative safety and low credit risk, and not a deterrent. In late summer 2008, for example, the U.S. dollar gained value against the euro even as interest rates in the U.S. were significantly lower because the likelihood of a U.S. default on Treasuries was deemed less than in Europe. The lack of a federal treasury-system meant responses to bank failure would be country-specific, keeping interbank lending rates in Europe at alarmingly high levels.

• Interest rates can also have economic effects, which influence currency exchange. Following the idea of supply and demand, speculators favor the currency of economies that are expanding, creating a virtual cycle of appreciation. An economy who's GDP is rising faster than its monetary base is by default increasing the value of its currency, and this will likely be reflected in currency exchanges.

• Interest rates can also have an effect on foreign countries. Japan, for example, set its interest rate well below the rest of the world. The result was a carry trade where speculators borrowed from Japanese banks and converted the yen into other higher-yielding currencies, driving up their relative value in the process. Unfortunately, this effect was one of the principal causes of the global savings glut that triggered the massive global banking failures of 2008.

Read more : http://www.ehow.com/how-does_4571522_interest-rates-affect-exchange-rates.html

Answer 5

Decrease in U.S. interest rates affect the EU/U.S. exchange rate

Governments can influence the level of the exchange rate directly or indirectly. Governments influence the exchange rate level directly by setting "fixed" exchange rates. This means that the rates stay at the same value until such time as a government sees fit to change them. Governments influence the exchange rate level indirectly by changing interest rates (the amount of money in circulation) or by purchasing other currencies on foreign exchange markets (the place where different currencies are bought and sold).

In addition, many countries, including the United States, Japan, and Canada, set "flexible" or "floating" exchange rates that change on a daily, or even hourly, basis, depending on currency demand and supply. Figure 1 illustrates how the U.S. dollar exchange rate for the European euro changed over the period 2001 to 2004. The downward sloping curve indicates a weakening of the U.S. dollar.

In general, when the exchange rate increases, For example, assume that the exchange rate between the U.S. dollar and the Japanese yen changed from US$1=104 yen to US$1=110 yen. This would strengthen the value of the U.S. dollar in that you would receive more yen in exchange for your dollar. Conversely, had the exchange rate changed to US$1=100 yen, the dollar would have weakened, depreciated, or decreased in value (devaluation) because now you would receive less yen for each dollar you exchange.

An increase in the demand for a country's currency on the foreign exchange market usually increases the value of its currency, too. For example, increased demand for U.S. exports would translate into a stronger U.S. dollar because other countries would be demanding more U.S. dollars in order to pay for these commodities and services. Likewise, foreigners wishing to invest in the United States or to repay debts owed to the United States would cause the demand for U.S. dollars to increase, which would result in the appreciation of the U.S. dollar. Of course, the converse is also true. Factors that increase the supply of or decrease the demand for a country's currency on the foreign exchange market tend to cause the exchange rate for that currency to weaken or lose value. Such factors include the desire of U.S. consumers and businesses to purchase foreign goods and services, or to transfer or repay debts owed outside the United States.

Use the carry trade to predict the impact of lower U.S. interest rates on Euro/$.

The effect of carry trades on exchange rates most likely depends on the magnitude of the international financial transactions and investment positions associated with them. Unfortunately, evidence on these magnitudes is fairly limited, in part because these strategies are generally conducted through transactions, such as currency swaps, that are reported as off-balance-sheet items and, therefore, hard to monitor through official statistics.

Two studies from the Bank for International Settlements (BIS), however, provide some evidence of the size of carry trade activity and thereby their significance in exchange rate movements. One study concerns foreign exchange market turnover, which measures the gross value in U.S. dollar equivalents of all transactions involving the exchange of two currencies. Galati and Melvin (2004) argue that the remarkable increase in foreign exchange market turnover between 2001 and 2004 was likely due to a rise in carry trade activities. They note that the increase in turnover was particularly strong for the Australian and the New Zealand dollars, two currencies with relatively high interest rates that simultaneously had extended periods of appreciation against low-interest-rate currencies, such as the U.S. dollar and the yen. The authors also illustrated graphically that, between 2001 and 2004, as the interest rate differential with the U.S. widened, the Australian dollar appreciated against the U.S. dollar and foreign exchange turnover increased substantially.

The second study concerns the stock of outstanding BIS reporting banks