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Chapter Objective:
Chapter Six
This chapter examines several key international parity p y relationships, p , such as interest rate parity p y and purchasing power parity.
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Chapter Outline
Interest Interest Rate Rate Parity Parity
Covered Interest Arbitrage Purchasing Purchasing Power Power Parity Parity PPP Deviations and Fisher The The Fisher Fisher Effects Effects Effects
International Forecasting ForecastingExchange Fisher Exchange Effects Rates Rates Purchasing Power Parity The Fisher Market Effects Efficient Approach
IRP and Exchange Rate Determination the Real Exchange Rate Reasons for Deviations from IRP Evidence on Purchasing Power Parity
The Fisher F Forecasting i Effects E Exchange h Rates R Fundamental Approach Forecasting Exchange Rates Technical Approach
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Interest Rate Parity Defined Covered Interest Arbitrage Interest Rate Parity & Exchange Rate Determination Reasons for Deviations from Interest Rate Parity
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IRP is an no arbitrage condition. If IRP did not hold, then it would be possible for a trader to make unlimited amounts of money exploiting the arbitrage opportunity. Since we dont typically observe persistent arbitrage conditions, conditions we can safely assume that almost all of the time! IRP holds.
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Variable Definitions
iH : Interest Rate in the home country iF : Interest Rate in the foreign country S = Current spot rate for the foreign currency (in direct quote) F = 1 year forward rate for the foreign currency (in direct quote) FPH = one year forward premium from the home countrys viewpoint = (F-S) / S FPF = one year forward premium from the foreign countrys viewpoint = (S- F) / F or (1/ FPH 1) iCH : Covered rate of interest, from the home countrys viewpoint iCF : Covered rate of interest, from the foreign countrys viewpoint (1 + i ) F$/ = S$/ (1 + i$)
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Since these investments have the same risk, they must have the same future value (otherwise an arbitrage would exist) (1 + i$) F F = S $/ $/ (1 + iF) = (1 + iH) (1 + i)
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1 + iH F = S 1 + iF 1 + iH 1 + iF -1 = FS S = FP
Or
Depending upon how you quote the exchange rates, direct (S, F) or indirect (SI, FI), we have:
1 + iF FI = 1 + iH SI
or
1 + iH F = 1 + iF S
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No matter how you quote the exchange rate (direct or indirect) to find a forward rate, increase the dollars by the dollar rate and the foreign currency by the foreign currency rate:
FI = SI
1 + iF 1 + iH
or
F= S
1 + iH 1 + iF
(1 + i)
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The interest rate available to an arbitrageur for borrowing, ib may exceed the rate he can lend at, il. There may be bid-ask spreads to overcome, Fb/Sa < F/S
Capital Controls
Governments sometimes restrict import and export of money through taxes or outright bans.
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The concept of Absolute and Relative Purchasing Power Parity (PPP) PPP and Exchange Rate Determination PPP Deviations and the Real Exchange Rate Consequences of PPP Violations Evidence on PPP
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A dollar should buy the same quantities of goods and services in all countries According to absolute PPP, in the long run, currencies should move towards the rate which equalizes the prices of an identical basket of goods and services in each country The exchange rate (direct quote) between two (S) currencies should equal the ratio of the countries price levels in the home (PH) and foreign (PF) country: S = (PH / (PF) Examples
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Absolute PPP probably doesnt hold precisely in the h real l world ld for f a variety i of f reasons:
Haircuts cost 10 times as much in the developed world as in the developing world. Film, on the other hand, is a highly standardized commodity that is actively traded across borders.
Shipping costs, as well as tariffs and quotas can lead to deviations from PPP.
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PPP: Evidence
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Even if the dollar does not buy the same basket of goods in other countries, the purchasing power of the h d dollar ll in i these h countries i could ld remain i stable bl over time. We can show that according to Relative PPP:
If two countries have different inflation rates, then the exchange rates between the two countries will adjust to maintain equality of relative purchasing power for the citizens of both countries. The real exchange rate will remain constant
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Variable Definition
S= Current spot rate (price of foreign currency) in direct quote S1 = Actual spot rate, 1 year from now F = 1-year forward rate FP = the forward premium = [(F-S) / S] = [(F/S) - 1] H = Inflation rate in the home country F = Inflation rate in the foreign country E(S1) = Expected spot rate, 1 year from now, based on PPP E(e) = [E(S1)/S] 1 = The expected percentage change, or rate of change, in the spot rate, based on PPP e = (S1/S) 1 = The actual percentage change, or rate of change, in the spot rate Sr= real spot rate
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Suppose the spot exchange rate (S) is $1.50 = 1.00 If the inflation rate in the U.S. (H) is expected to be 5% in the next year and 3% in the euro zone(F), Then the expected exchange rate in one year E(S) should be such that $1.50(1.05) = 1.00(1.03)
$1.50(1.05) 50 (1 05) $1.575 $1 575 = $1.5291 E(S1) = $1 = 1.00(1.03) 1.03 E(e) = [E(S1)/S 1] = $1.5291 - 1 = .019 = 1.94% $1.50
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Because of the inflation differential, the euro is expected to appreciate by 1.94% in the spot market by the end of the year:
E(S1) = S
1.05 1 + H = 1.03 1 + F
Relative PPP states that the rate of change in the exchange rate is equal to differences in the rates of inflationroughly 2% Also remember that E(S1) = F So that: expected rate of change in the exchange rate = forward premium, or E(e) = FP
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Sr
S1
Under PPP, real exchange rates should remain constant Suppose the US the current spot rate for is 1.50 and US inflation rate is 5% while the inflation rate is 3% in the euro zone If the spot rate next year turns out to be 1.52, zone. 1 52 the real exchange rate is: 1.52*(1.03/1.05) = $1.491
We can say that although the spot rate for appreciated in nominal terms from $1.50 to $1.54, it actually depreciated in real terms from $1.50 to $1.491 This would weaken the USs competitive position against Europe
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= = = E(S1)/S1
q = 1: Competitiveness of home country is unchanged q < 1: Competitiveness of home country has improved q > 1: Competitiveness of home country has deteriorated
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PPP: EXAMPLE 1
Inflation rate in the US is 5%; H = 0.05 Inflation rate in the Europe is 3%; F = 0.03 Current spot rate for is $1.50; S = 1.50 To maintain relative PPP PPP, the expected percentage change in the spot exchange rate for , E(e) = (1.05) / (1.03) - 1 = 1.9417 % To maintain relative PPP, the expected spot exchange rate for , at the end of the year, E(S1) = $1.50 ( 1 + 0.019417)= $1.5291 per
$1.54 higher 2 027 % 2.027 $1.5107 0.9929 increased appreciated improved $1.52 lower 1 333 % 1.333 $1.4910 1.0060 decreased depreciated deteriorated
If, 1 year latter the actual spot rate, S1 for turns out to be Compared to E(S1) of $1.5291, S1 is Actual % change in S: e = (S1/S) -1 1 The real rate for , Sr = S1 *[1.03/1.05] q is equal to: [1+E(e)] / [1 + e ] = E(S1)/S1 The real rate (Sr) has: In real terms, has: USs competitiveness has:
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PPP: EXAMPLE 2
Inflation rate in the US is 5%; H = 0.05 Inflation rate in the Switzerland is 2%; F = 0.08 Current spot rate for SF is $0.90; S = 0.90 To o maintain relative e ve PPP, , the e expected pe percentage ce tage c change a ge i in t the e spot exchange rate for SF, E(e) = (1.05) / (1.08) - 1 = - 2.778 % To maintain relative PPP, the expected spot exchange rate for SF, at the end of the year, E(S1) = $0.90 ( 1 + 0.02941)= $0.875 per SF
$0.88 higher - 2.222 2 222 % $0.9051 0.994 increased appreciated improved
If, 1 year latter the actual spot rate, S1 for SF turns out to be $0.86 Compared to E(S1) of $0.875, S1 is Actual % change in S: e = (S1/S) -1 1 The real rate for SF, Sr =S1*[1.08/1.05] q is equal to: [1+E(e)] / [1 + e ] = E(S)/S1 The real rate (Sr) has: In real terms, SF has: USs competitiveness has:
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Notice that the PPP & IRP equations are equal because E(S) = F or E(e) = FP: IRP PPP F 1 + iH E(S) 1 + H = = 1+i = S S 1 + F F
E(e) =
1 + H -1 = 1 + F
1 + iH -1 = FP 1 + iF
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PPP: Evidence
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F($/) 1 + $ = S($/) 1 +
Fisher Effect
The nominal interest rate is composed of a real interest rate and an expected inflation rate.
Nominal interest rate: i; Real rate: ; Expected inflation:
(1 + i) = (1 + ) (1 + ) i = + + Approximately: i = + If real rates are equal across countries, or: H = F Then: (1 + iH) / (1 + iF) = (1 + H) / (1 + F) Approximately : iH - iF = H - F
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The concept of IEF IFE Conditions Deviations of from IFE: uncovered rates of interest: from the home and foreign countrys view point
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The exchange rate of a country with a higher (lower) interest rate than its trading partner should depreciate (appreciate) by the amount of the interest rate difference to maintain equality of real rates of return.
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IFE: Terminology
iH = Nominal interest rate for the home country g country y iF = Nominal interest rate for the foreign S = Current spot rate (direct quote) for the foreign currency (in home currency units) S1 = Next years spot rate (direct quote) for the foreign currency
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The uncovered rate from the home countys point of view (iUH) is the rate earned by the holders of dollars by: 1. Converting DOLLARS into FOREIGN CURRENCY today at the current spot exchange rate (S), and 2. Investing the FOREIGN CURRENCY at the FOREIGN INTEREST RATE (iF), and 3. Converting FOREIGN CURRENCY back into DOLLARS at maturity using the future spot exchange rate (S1) This return is affected by two factors: whether the foreign currency appreciates or depreciates against the dollar = % change in direct quote (DQ) = (S1 - S) / S The rate of interest you earn in the foreign country = iF iUH = (1 + % change in DQ)*(1 + iF) 1
Profit making Strategy: If iUH > iH then borrow in dollars and invest in foreign currency If iUH < iH then borrow in foreign currency and invest in dollars If iUH = iH then you cannot make any profit
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The uncovered rate from the foreign countys point of view (iUF) is the rate earned by the holders of foreign currency by: 1. Converting FOREIGN CURRENCY into DOLLARS today at the current spot exchange rate (S), (S) and 2. Investing the DOLLARS at the US INTEREST RATE (iH), and 3. Converting DOLLARS back into FOREIGN CURRENCY at maturity using the future spot exchange rate (S1) This return is affected by two factors: whether the US Dollars appreciates or depreciates against the foreign currency = % change in indirect quote (IQ) = (S0 - S1) / S1 The rate of interest you earn in the home country (US) = iH iUF = (1 + % change in IQ)*(1 + iH) 1
Profit making strategy : If iUF > iF then borrow in foreign currency and invest in dollars If iUF < iF then borrow in dollars and invest in foreign currency If iUF = iF then you cannot make any profit
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IFE Conditions
According to IFE one should not be able to make money by consistently borrowing in one country and investing in another These conditions are met when: iUH = iH or iUF = iF According to IFE the above conditions will hold only when the expected percentage change in the spot rate, E(e): E(e)= (1 + iH) / (1 + iF) 1 Approximately: E(e)= iH - iF According to IFE IFE, the expected spot rate 1 year from now, now E(S1), should be: E(S1) = S [1 + E(e)]
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borrow in the home country (US) convert the $ loan amount into foreign currency invest in the foreign capital market at the h end d of f the h b borrowing/investment i /i period i d convert the h foreign f i currency back b k into domestic currency ($) and pay off the domestic (US) loan If this continues then: S, E(S1), iH, iF, until iUH = iH or iUF = iH, or IFE holds
borrow in the foreign country convert the loan amount from foreign currency into domestic currency ($) invest in the domestic (US) capital market at the end of the borrowing/investment period convert the domestic currency ($) back into foreign currency and pay off the foreign loan If this continues then: S, E(S1), iH, iF, until iUH = iH or iUF = iH, or IFE holds
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IFE : Example 1
Interest rate in US, iH = 7 % & Euro zone interest rate, iF = 9 % Current spot rate for , S = $1.40 According to IFE, the percentage change in exchange rate, based on direct quote, quote for should be: E(e) = (1.07) / (1.09) - 1 = - 1.83486% According to IFE, the expected spot rate for at the end of the year should be: E(S1) = $1.40 ( 1 - 0.0183) = $ 1.37 / What happens if you believe (predict) that S1 will be $1.39 ? You could make money by borrowing in $ and investing in Can you show how? What happens if you believe (predict) that S1 will be $1.35 ? You could make money by borrowing in and investing in $ Can you show how?
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IFE : Example 2
Interest rate in US, iH = 7% & Interest rate in Switzerland, iF = 3% Current spot rate for SF (S)= $0.85 According to IFE, the percentage change in exchange rate, based on direct quote, quote SF should be: E(e) = (1.06) / (1.03) - 1 = 3.8845% According to IFE, the expected spot rate for SF at the end of the year should be: E(S1) = $0.85 ( 1 + 0.0288) = $0.883 / SF What happens if you believe (predict) that S1 will be $0.90 ? You could make money by borrowing in $ and investing in FF Can C you show h how? h ? What happens if you believe (predict) that S1 will be $0.87 ? You could make money by borrowing in SF and investing in $ Can you show how?
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( iH iF)
FS S
E(H F)
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IFE
FEP
1 + iH 1 + iF
F S
E(1 + H) E(1 + F)
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Variable Definitions
S= Current spot rate (price of foreign currency) in direct quote S1 = Actual spot rate, 1 year from now F = 1-year forward rate FPH = the forward premium = [(F-S) / S] = [(F/S) - 1] from the home countrys view point FPF = the forward premium = [(S-F) / F] = [(S/F) - 1] from the foreign countrys view point H = Inflation rate in the home country F = Inflation rate in the foreign country = Real rate of interest E(S1) = Expected spot rate, rate 1 year from now now, based on PPP E(e) = [E(S1)/S] 1 = The expected percentage change, or rate of change, in the spot rate, based on PPP e = (S1/S) 1 = The actual percentage change, or rate of change, in the spot rate Sr= real spot rate iH = Nominal interest rate for the home country iF = Nominal interest rate for the foreign country
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The IRP relationship holds when the expected forward premium from the home countrys point of view (FPh ):
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