[Q:]: My question is concerning the Canadian Dollar. Is there any possible assumption that the Canadian Dollar might improve in the near future?
[Q:]: The Canadian Dollar has risen substantially over the U.S. Dollar. My question: What are the main reasons for this rise and do you foresee continued rise to par?
[A:]: Thanks for your terrific questions!
The article "Is the Value of the Canadian Dollar related to Oil Prices? published in 2005 showed that the massive increase in the value of the Canadian Dollar is almost wholly due to increases in the price of oil. I highly recommend that anyone interested in the topic read the article, but for the sake of brevity, here are the hilights:
- The 0.8477 figure (for the correlation between movements in the Canadian Dollar and oil prices) is exceptionally high, denoting that there is a very, very strong positive relationship between movements in oil prices and movements in the value of the Canadian dollar.
- Thus if we believe this trend to continue then the Canadian dollar will hit "par" when oil reaches $92 a barrel. I've heard from economic analysts who have far more sophisticated models that par should be achieved when oil reaches around $100 a barrel, which is quite close to the results in our simple statistical model.
The previous article indicated that the Canadian Dollar was likely to hit par with the U.S. Dollar if oil prices reached $90-100 a barrel. That simple statistical model was calculated in 2005, so I thought I should see if the relationship still holds in 2006. I'll follow the same methodology used in the previous article and see how much (if at all) the results change using more current data.
I chose to look at daily data from the time period January 1, 2005 to April 25, 2006 - a sample of 329 trading days. The start date of this period was chosen rather arbitrarily by me. There may be another date that would make more sense, but this should be adequate for our purposes.
As before, I found the correlation between oil prices and the Canadian-American exchange rate. In the previous article, with the time period January 1, 2002 to September 30, 2005 we found that the correlation between the two sets of data was 0.8477, which indicates an extremely strong relationship between oil prices and the exchange rate. For the period January 1, 2005 to April 25, 2006, I found the correlation to be 0.7300 - not as high as before, but still very high. High enough for me to re-use my earlier comment:
The 0.7300 figure is exceptionally high, denoting that there is a very, very strong positive relationship between movements in oil prices and movements in the value of the Canadian dollar.
As with the previous article, I then estimated the linear relationship between the exchange rate and oil prices. Previously I found the relationship to be:
y = 0.54 + 0.005x
Since the exchange rate is on the y axis and oil prices are on the x axis, this gives us the relationship:
Exchange Rate = 0.54 + 0.005 Oil Prices
In the 2005-2006 period, I found the relationship to be:
Exchange Rate = 0.68 + 0.0028 Oil Prices
We can interpret the two numerical figures as follows:
0.68 is the Y-intercept. In this case it is the value of the Canadian-American exchange rate if X (oil prices) goes to 0.
0.0028 indicates the relationship between changes in oil prices and changes in the exchange rate. Here it means that whenever oil prices go up a dollar, the Canadian dollar gains about three-tenths of a cent on the U.S. one. Note that in the earlier sample, this figure was 0.5, indicating that it is taking relatively larger movements in oil prices to have the same impact on the Canadian dollar.
There's all kinds of useful information we can gather from this data. We can find out when the Canadian dollar will be equal to the U.S. dollar, if we believe this relationship is to continue into the future. We simply substitute "$1.00" into the value for the exchange rate then re-arrange:
1.00 = 0.68 + 0.0028 Oil Prices
0.32 = 0.0028 Oil Prices
Oil Prices = $114
Thus if we believe this trend to continue then the Canadian dollar will hit "par" when oil reaches $114 a barrel. In the previous article, we calculated the figure to be closer to $92 a barrel. These are rather crude estimates compared to the sophisticated models that analysts use, so I'm still fairly confident in my prediction that if the price of oil reaches $100 a barrel, the value of the Canadian Dollar should be at or very close to par with the U.S. Dollar.
If you have a question free to send it to me using the feedback form.
