Money markets

[Student_1985]

Can anyone help explain the answer to this past paper question please?

September CA1 paper 1 September 2005 Question 1:
Describe the circumstances under which money market instruments may be temporarily unattractive to investors (attractive to investors).

Solution:
Expecation of a strengthing in domestic currency (weakness of the national currency making cash investments in other currencies attractive).

Thanks

 

[Exam_Machine]

I would have thought that all you needed for this question was to reverse the circumstances in the core reading under which MMI's are attractive?

 

[Student_1985]

Initially that's what I thought.

But I can't seem to understand the logic of why an expectation in the strengthing in domestic currency would make MMI unattractive?

 

[didster]

I think it's a silly answer but before I say why I think so, here is the examiner's reasoning. My rant follows after.

If you expect the local currency to weaken, you could temporarily invest in foreign currency. When your currency falls, you can sell the foreign currency to make a (currency) profit.

If your goal is to capitalise on this profit, you may invest in foreign money market intruments.
Other asset classes are volatile, and may move in such a way to negate the currency effect. They may not however.

So the core reading says that expectations of a weakening local currency makes foreign cash (in the sense of money market investments) attractive.

If expectations of weakening currency makes foreign cash attractive, strenghtening of the currency should make foreign cash unattractive.

That's the reasoning behind the examiners solution.

I (personally) don't quite agree with it because it just highlights how dependant we are on lists for exams (despite being a supposedly application subject). Firstly, the above example is a very specific example. Attractiveness isn't binary (black and white) where something is attractive or not, it is a wide spectrum, so I feel "not (very) attractive" doesnt necessarily mean (flat out) unattractive.
By similar reasoning on an equally specific hypothetical situation, strengthening of local currency implies global relative (average) weakening of foreign currencies. They will be inclined to invest in the cash of strenghtening curencies actually making local cash attractive.
So currency considerations wouldn't be at the top of a list for reasons making cash (in general) unattractive (unless of course your knowledge primarily relates to core reading lists rather than application of concepts).

 

[Student_1985]

Thanks didster!

I completely agree with you and I think you understand my confusion. Adding the word 'foreign' seems to give the answer much more credibility.

Thanks again.

 

[ST6_aspirant]

So when we write "strengthening of local currency makes investment in local MMI attractive", is it a legitimate answer?

I personally see it as only the opposite of the bookwork (weakening of local currency makes MMI is overseas currency stronger and hence local MMI unattractive), and thus, maybe not as valid a point as one would like to make.

 

[Lindsay Smitherman]

An expected strengthening of the domestic currency would make domestic MMIs attractive to overseas investors but would not make them more attractive to domestic investors - so you would need to phrase such a point quite carefully.

And if the outlook for interest rates is lower (less need for high interest rates to support the value of the currency once it has strengthened) then this would reduce the attractiveness.