Question

1. The following rates of interest and exchange rates are prevailing within Australia and Canada:

Country	Interest Rates
Australia	5%
Canada	11%

Exchange Rate          - (AUD/CAD) 0.7375-0.7425

1. What are the key macro-economic factors that influence exchange rates?
2. If uncovered interest rate parity theory holds, what will happen to the AUD/CAD exchange rate?
3. Estimate the forward rate based on the current exchange rates and rates of interest.

Answer 1

a. i. ) Following are the key macro-economic factors that influence exchange rates:

1. Inflation Rates: Countries with low rate of inflation exhibits an appreciation in the value of the currency as its purchasing power rises relative to other countries. On contrary, countries with high rate of inflation tend to see depreciation in their currencies.

2. Interest Rates: A rise in the rate of interest result in appreciation of a country's currency as lenders are provided with higher interest rate which attracts more foreign captal resulting in a rise in exchange rates.

3. Balance of Payments: Current account consists of earnings and balance of trade on foreign investments. A current account deficit indicates that the value of imports exceeds the value of exports. A country will witness a depreciation in the currency if it strives to attract capital inflows for financing the deficit in current account.  

4. Economic Growth/ Recession: During the stage of recession, exchange rate may depreciate as interest rates are likely to fall reducing the chances of acquiring foreign capital.

ii. "Uncovered Interest Rate Parity is the condition in which the difference in interest rates between two nations is equal to the expected change in the exchange rates between those nation's currencies."

An investor can invest in Australian market at a rate of interest of 5% or could invest in Canadian market at a interest rate of 11% multiplied by the exchange rate between Australia and Canada. If there is uncovered interest rate parity between the two investments, the Canadian dollar would depreciate against the Australian Dollar by 6% i.e. the expected change in the interest rate will be equal to the gap between the two interest rate i.e. 6%

iii. Forward Rate= Spot Rate * [(1+Interest rate of foreign country)/(1+interest rate of domestic country)]

= 0.74 * (1.11/1.05)

=0.78

Here, spot range is (0.7375+0.7425)/2 = 0.74