Friday, August 3, 2007

Canadian dollar getting loonie


The rally in the Canadian dollar has been one of the best in the G10 currency markets over the last few years. In fact, all of the Anglo currencies have done well but a simple model of purchasing power parity may suggest that it is time to call it quits. We ran purchasing power parity calculations since 1981 and placed a five percent range around the PPP exchange rate. The Canadian dollar has come off its tremendous undervaluation, but it has now turned to being rich for the first time in almost fifteen years. This makes it a good time to reassess the Canadian dollar. Now the PPP model has fallen in and out of favor over the course of time, but the latest research still suggest that this model is effective for long-term valuations. There are more complex models which are more effective but PPP is a good workhorse for long-term valuation discussions.

We use it in a very simple manner. If the exchange rate deviates from fair value, we flag it for observation. These misvaluations may last for a long period so this by itself may not be an indication for strong action. There may be a reason to reduce long positions, but we are very interested when the exchange rate is away from fair value and starts to move back to equilibrium. These are the points for greatest opportunity. By this criteria, we have flagged the Canadian dollar as moving outside the fair value range. We will see if there is a move back to fair value which is a good opportunity, in this case, for selling the currency.

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