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Is the Canadian Dollar a Petro Currency?

Instructor’s comment: This is one of the simplest but best example of “investigative paper”.

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Is the Canadian Dollar a Petro Currency?

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  1. 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

  2. Common Factors that Effect the Value of Canadian Currency • 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 interest-sensitive 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.

  3. 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?

  4. A Simple Regression Experiment **See Attached Excel Sheet for Data and Regression results**FXvsCrude.xlsxFXvsCrudeRegression.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.

  5. 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.

  6. Results continued • 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

  7. Results Continued

  8. Analysis of Regression Results • AnR2 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.

  9. 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.

  10. An Attractive Oil Play: CAD/JPY 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

  11. References: 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-three-week-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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