Is the Canadian Dollar a Petro Currency?

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Instructor’s comment: This is one of the simplest but best example of
“investigative paper”.
I can further suggest to improve the regression by adding the conventional
variables of interest rate differentials between Canada and U.S., price level
differentials, and income (growth rate) differentials. By doing this, you are
controlling /remove the impacts of those factors and are examining the
impact of oil price on the Canadian dollar value in separation. An excellent
work!
Is the Canadian Dollar a Petro
Currency?
A simple experiment and further
analysis
Common Factors that Effect the Value of
Canadian Currency
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Relative Economic Growth: A strong economy makes Canada an attractive place
to invest in because of the promise of solid financial returns. This raises demand
for Canadian dollars, which in turn raises their price on international markets.
Interest Rate Differentials: When Canadian interest rates are higher than those in
the United States, Canada becomes a more attractive destination for interestsensitive foreign capital because the rates of return are higher. This results in
higher demand for assets denominated in Canadian dollars (e.g., short-term paper,
bonds) and thus places upward pressure on the dollar itself.
Inflation Rate Differentials: If prices in Canada were to rise faster than in the
United States, this situation would, over time, erode the purchasing power – and
thus the value – of the Canadian dollar relative to the US dollar. That erosion of
value would be reflected in a decline in exchange rates.
Above the Line Current Account Balance: A positive settlements balance implies a
net capital inflow. This implies increased demand for Canadian dollars, pushing up
the value of the currency. The opposite is also true: a negative settlements balance
suggests a flow of money out of Canada, placing downward pressure on the
exchange rate.
The Canadian Dollar as a Commodity
Currency
• Quit often in the news it is said that the Canadian dollar is a commodity
currency and that it’s value rises and falls based on changes in commodity
prices, most importantly oil prices, Canada's #1 export.
• From a supply and demand stand point this makes sense since as oil prices
rise it takes more Canadian dollars to buy a barrel of oil, thus leading to
increased demand for Canadian dollars, which in turn increases the
currency’s value. However, due to Econ 3370 and explained in the previous
slide we know that there are more factors that effect foreign exchange
rates in Canada. These include relative economic growth, interest rates,
inflation and the current account balance.
• Canada exports around 2 million barrels of oil a day to the United States. If
the price of a barrel of oil is $50 U.S., that is $100 million (U.S.) in
purchases that occur every day. Because of the magnitude of sales
involved, any changes to the price of oil must have an impact on currency
markets.
• So the question becomes; do variations in energy prices effect Canadian
exchange rates? And if so, how much?
A Simple Regression Experiment
**See Attached Excel Sheet for Data and Regression results**
FXvsCrude.xlsx
FXvsCrudeRegression.xlsx
• In order to quantify the effects of changes in oil prices on Canadian foreign
exchange rates, I decided to run a simple regression analysis in excel using
two data sets. Daily oil prices vs. Canadian/U.S. exchange rates for the past
4 years.
• The historical oil pricing came from the Energy Information Administration
(http://www.eia.gov/dnav/pet/pet_pri_spt_s1_d.htm) and the exchange
rate data is from the BOC web site.
• However, since oil is priced in USD, I had to convert the exchange rate data
to 1/(CAD/USD). In other words, I had to convert the FX rate to be in terms
of American dollars. (See attached excel sheet FXvsCrude.xlsx)
• With the historical data of oil prices in one column and exchange rate data
in another column lined up with coinciding dates, It was easy to perform
some common statistical analysis (correlation) and run a regression, since
these tools are built right into excel.
Results
Correlation: (See attached excel sheet FXvsCrude.xlsx)
Correlation coefficients are between -1 and 1. A correlation
above zero means there is a positive correlation between two
variables. Given the supply and demand effects changing oil
prices have on demand for Canadian currency, there will be
some positive correlation between oil prices and Canadian FX
rates. However, there are other factors that influence the value
of the Canadian dollar, so the correlation should be far from
perfect. In the case of oil prices vs. Canadian/U.S. exchange rates
the correlation coefficient turned out to be 0.76! This figure is
very high, meaning there is an exceptionally positive
correlation between movements in oil prices and movements
in the value of the Canadian dollar. In other words as oil goes
up so to does the Canadian dollar and vice versa.
Results continued
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Regression Stats: (see FXvsCrudeRegression.xlsx)
R-squared: 0.57
Y – Intercept: 0.75
Slope: 0.0023
Linear relationship: y = 0.75 + 0.0023x
FX = 0.75 + 0.0023oilprice
Results Continued
60.77 Line Fit Plot
1.2
1
USD to buy
CAD
0.8
0.6
Series1
Predicted 0.858442785
0.4
0.2
0
0
20
40
60
80
Oil Price
100
120
140
160
Analysis of Regression Results
• An R2 of 57% indicates that roughly 57% of the variance in the Canadian-American
exchange rate is "explained" by the variance in oil prices.
• The regression calculated the y-intercept to be roughly 0.75. This means that
according to this experiment the value of the Canadian dollar would be 0.75 USD
if oil prices were to go to zero.
• The slope of 0.0023 indicates the relationship between changes in oil prices and
changes in the exchange rate. According to our results whenever oil prices go up a
dollar, the Canadian dollar gains roughly a quarter a cent on the U.S. one.
• Further, to determine when the Canadian dollar will be at par with the U.S. dollar
substitute 1 into the equation (1=0.75+0.0023oilprice). After rearranging you get
an oil price of roughly $109. So accordingly if oil hits $109 a barrel the Canadian
dollar should be very close to par with the U.S. dollar.
Conclusions
•
The results definitely confirm the headlines. The Canadian dollar and oil prices are
moving in tandem. They are very highly correlated and a significant proportion of the
Canadian dollar’s value is based on the price of oil.
•
However, it would be interesting to run further tests on a larger sample of data. One
cause for concern for me is that this 4 year period of data included the 2008 recession
and market crash. This “abnormal” period may skew the results. Oil prices hit abnormal
lows and investors flocked to the U.S. dollar for security during a time of vast
uncertainty. In other words “normal” market conditions were not present for much of
this experiment's data, although many economists believe large market uncertainty to
be the new “normal”.
•
As Canadian oil sands resources are continually developed, Canada becomes a larger
exporter of oil to the world. This will continue to make Canadian currency more sensitive
to oil price fluctuations. This could be dangerous as spikes in oil prices will hurt (in short
run) many important sectors in Canada that rely on a lower dollar, such as tourism and
manufacturing. On the other side significant oil price decreases will drive down the
Canadian dollar making it harder for Canadian businesses to expand to other countries
and invest for the future by importing from abroad.
•
Overall the BoC should consistently be monitoring the price sensitivity of the Canadian
dollar to oil prices and be enacting policies and programs that give the BoC more control
over this matter.
An Attractive Oil Play: CAD/JPY
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Japan’s lack of domestic sources of energy, and its need to import vast
amounts of crude oil, natural gas and other energy resources, make it
particularly sensitive to changes in oil prices.
Since Canada is a net exporter and Japan a net importer of oil, the currency
pair to use to make a play on one’s view of oil prices is the Canadian dollar
vs. the Japanese yen. (See Chart below for the tight correlation between oil
prices and CAD/JPY)
Therefore if one believes oil prices are set to rise they should have their
assets in Canadian dollars and Liabilities in JPY, as the Canadian dollar will
gain significantly in value vs. the JPY when oil prices rise.
Vice versa if one believes oil prices are set to fall
References:
1.
2.
3.
4.
5.
6.
Why Do Oil Prices and the Canadian Dollar Move Together?
(http://economics.about.com/od/pricesexchangerates/a/oil_and_dollars.htm)
Commodity Prices And Currency Movements by Kathy Lien
(http://www.investopedia.com/articles/forex/06/CommodityCurrencies.asp)
Bank of Canada (www.bankofcanada.ca)
http://www.bloomberg.com/news/2010-12-06/loonie-falls-from-almost-threeweek-high-before-bank-of-canada-s-meeting.html
Explaining the Rise in the Canadian Dollar Prepared by: Michael Holden
Economics Division
(http://www2.parl.gc.ca/content/lop/researchpublications/prb0326-e.htm)
Historical Oil Price Data http://www.eia.gov/dnav/pet/pet_pri_spt_s1_d.htm

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