Question

1. Explain the factors that determine foreign exchange rates and their link to financial markets. In terms of balancing mechanisms, how does covered interest arbitrage ensure market equilibrium?

Answer 1

Foreign exchange is a rate at which a country’s currency is converted into another country’s currency. Foreign exchange rates provide an insight into a country’s economic stability and are therefore vital to be constantly monitored and analyzed.

Below mentioned are the factors that determine a country’s foreign exchange rates:

1. Inflation rates: Any change in market inflation has an impact on foreign exchange rates. A country having lower inflation will witness an appreciation in the value of its currency in comparison to another country that has a higher inflation and vice versa.
2. Interest rates: Increasing interest rates also appreciates the value of a currency because it attracts increased foreign capital and therefore the demand of the currency rises.
3. Government debt: Increase in government debt decreases the value of the currency and vice versa. Increasing government debt forces foreign investors to exit from the country by selling their bonds and thus the value of the currency depreciates resulting in decreased foreign exchange rates.
4. Terms of trade: Whenever a country’s exports exceeds there imports, the value of that country’s currency increases as it increases demand for its currency. This results in increased foreign exchange rate for that country’s currency in relation to other currencies.
5. Recession: A country experiencing recession sees a likely fall in interest rates resulting in weaken currency which in turn also decreases foreign exchange rates.

Covered interest arbitrage strategy involves usage of a forward contract for mitigating exchange rate risk. In this strategy, an investor uses the favorable difference in interest rates or investing in high-yielding currencies and in turn hedging the exchange rate risk by using a forward currency contract.

Such arbitraging opportunities are not very common as the market participants quickly exploit such arbitrage opportunities and this resulting demand quickly redresses any market imbalance that was created.