International and Monetary Economics

Course Code: 30054

Professor: Dmitriy Sergeyev

Lecture 5

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 Roadmap
1. Interest rate parity
– Demand for currency deposits (material from the last time)
– Equilibrium (material from the last time)
– Diagram
– UIP vs. CIP
– Empirical evidence

2. UIP and the Carry Trade

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The Demand for Currency Deposits

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 Demand for Foreign Currency Assets
• The demand for a foreign currency bank deposit depends on
the same factors that affect any other asset demand
– Rate of return
– Risk
– Liquidity
• Rates of return on a foreign currency deposit depend
– interest rates that the assets will earn
– exchange rate growth expectations
Demand for Foreign Currency Assets
Interest rates in US and Japan

Source: Datastream. Three-month interest rates are shown.

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 Demand for Foreign Currency Assets
Example in which the US is home country
• Dollar deposit interest rate is 𝑅$ = 2%
• Euro deposit interest rate is 𝑅€ = 6%
• Exchange rate today is 𝐸$/€ = 1$/€
Dollar appreciates, Euro depreciates
𝑒
• Expected exchange rate in one year is 𝐸$/€ = 0.97$/€
• Investing in euro deposits
– $100 can be exchanged today for €100
– These €100 will yield €106 after one year
– These €106 are expected to be worth €106 × 0.97 = $102.82
Demand for Foreign Currency Assets
Example in which the US is a home country

$102.82 – $100
2% = 2.82%
$100
 Demand for Foreign Currency Assets
• Note that the expected rate of appreciation of the euro or, equivalently,
the rate of depreciation of the dollar is dollar appreciates
𝐸 𝑒 − 𝐸 0.97 − 1
= = −3%
𝐸 1
however, since I converted my $ to € at a higher exchange rate, my return will be lower in $ because of $ appreciation
• The dollar rate of return on Euro deposits approximately equals:
– the interest rate on euro deposits
– plus the expected rate of appreciation of € or depreciation of $
6% + −3% = 3%
𝐸 𝑒 −𝐸
Expected rate of return on a foreign deposit ≈ 𝑅€ + 𝐸
Equilibrium

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 Equilibrium on the Forex Market

• Equilibrium
– deposits of all currencies offer the same expected return

• We will call it the interest parity (or interest rate parity)

 Equilibrium on the Forex Market
𝑒
∗
𝐸 −𝐸
𝑅=𝑅 +
𝐸
Why should this condition hold?
• Assume 𝑅 < 𝑅∗ + (𝐸 𝑒 − 𝐸)/𝐸
• No investor wants to hold home deposits
• Demand for deposits in domestic currency ↓
• Demand for deposits in foreign currency ↑
• Home currency depreciates 𝑬 ↑ (assuming that 𝐸 𝑒 is fixed)
 Back to Numerical Example
return on
foreign
𝑒
return on domestic asset
∗
𝐸 −𝐸
asset
𝑅=𝑅 +
𝐸
• In our numerical example: 𝐸 = 1; 𝐸𝑒 = 0.97; 𝑅$ = 2%; 𝑅€ = 6%

• This imlies 𝑅 < 𝑅 ∗ + (𝐸 𝑒 − 𝐸)/𝐸 because 2% < 2.82 %

• The dollar (domestic currency) must depreciate (E ↑) to a new level

𝐸 ≈ 1.01
A Useful Diagram

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A Convenient Way to Represent the Parity
$ = domestic currency
€ = foreign currency
Intersection occurs where the equation
𝐸𝑒 − 𝐸
of interest parity holds true

𝑅$ = 𝑅€ +
𝐸
R€ + (Eexpected/E) -1

Return on Foreign Investment depends negatively on the exchange rate ($/€, US home)
depends positively on
the domestic interest
rate
does not depend on the exchange rate
Note: 𝑅€ and 𝐸 𝑒 are fixed on this diagram
 Exercise 1
A Decrease in Domestic Interest Rate
Return on
𝐸 domestic
assets
At 𝐸1 , the expected rate of
return on foreign assets is
higher than 𝑅2
𝐸2 2 ⇓
1
higher demand for foreign
𝐸1
currency
Expected return on
foreign assets
⇓
the domestic currency
depreciates
𝑅2 𝑅1 𝑅
 Exercise 2
A decrease in the foreign interest rate
Return on
𝐸 domestic At 𝐸1 , the expected rate of
assets
return on foreign assets is
lower than 𝑅1
⇓
higher demand for domestic
1
𝐸1 currency
𝐸2 2 Expected return on ⇓
foreign assets
the domestic currency
appreciates.
𝑅1 𝑅
 Exercise 3
An increase in 𝐸 𝑒
Return on
𝐸 domestic 𝐸𝑒 ↑
assets
⇓
higher demand for foreign
currency
⇓
2
𝐸2 the foreign currency
𝐸1 1 Expected return on appreciates/the domestic
foreign assets
currency depreciates

𝑅1 𝑅

The exchange rate behaves like any other asset price: its value today
depends on expectations of its value in the future
 Interest Parities
1. Covered interest parity (CIP)
𝐹−𝐸
∗
𝑅=𝑅 +
𝐸
– 𝐹 is the forward exchange rate
– Forward exchange contract covers the FX risk

2. Uncovered interest parity (UIP)

𝑒
∗
𝐸 −𝐸
𝑅=𝑅 +
𝐸
– Uncovered because exposes to exchange rate risk
Empirical Evidence
on CIP and UIP

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Evidence on CIP

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capital control —> less arbitrage opportunities

TAXES!!!!!

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CIP during and after the Global Financial Crisis

Source: Du, Tepper, Verdelhan (2018)

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 riskless arbitrage??

Evidence on CIP
• CIP holds remarkably well most of the time
• But sometimes it does not hold because of
– capital controls taxes
– counterparty/liquidity risk default risk

– Financial regulations
• Examples of the recent deviations
– Following the collapse of Lehman Brothers, counterparty risk
increases enormously
– Persistent deviations after that due to new regulations that limit
financial positions of banks
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 (E(expected) - E )/ E = R - R(star)

Evidence on UIP
• A realized (actual)
rate of depreciation
on Y axis
• The plot shows that
– UIP does not seem
to hold
– This observed
failure of the UIP is
usually called the
forward premium
puzzle

Interpreting the slope of the best fit line: for every 1% of interest differential in favor of the foreign currency, we would
expect only a 0.2% increase in the rate of appreciation of the home currency, on average, leaving a profit of 0.8%. 27
 Evidence on UIP
• An expected rate of
depreciation on Y axis
(surveys of currency
traders)
• The plot shows that
– UIP does not seem to
hold precisely
– However, there is a
good positive relation

• Based on this
evidence, we will treat
the UIP as a useful
approximation
Data are monthly for the German mark, Swiss franc,
Japanese yen, British pound, and Canadian dollar against
the U.S. dollar from February 1988 to October 1993
Source: Menzie Chinn and Jeffrey A. Frankel, 2002,
“Survey Data on Exchange Rate Expectations: More 28
Currencies, More Horizons, More Tests.”
UIP and the Carry Trade

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 Carry Trade
• Motivation

• A carry trade investment strategy

– Borrow in a low interest rate currency (funding currency)
– Invest in a high interest rate currency (target currency)
– Pray that the funding currency doesn’t appreciate against the target
currency!
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Carry Trade:
Borrow in Yen, invest in AUD

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 Carry Trade: Borrow in Yen, invest in AUD
• AUD appreciates most of the time, but can abruptly depreciate
– With prob. 90% AUD appreciates by 1% against the Yen
– With prob. 10% AUD depreciates by 40% again the Yen
– Expected rate of depreciation of Yen = 0.9 × 0.01 + 0.1 × −0.4 = −0.031
– This is potentially consistent with the UIP

• Another potential explanation of the forward premium puzzle

– positive carry trade returns can be a compensation for this “disasters” risk
(Brunnermeier, Nagel, Pedersen, 2008). That is, abrupt exchange rate
movement occur during financial crises when other risky assets lose value
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Skewness of exchange rate changes
and Interest Rate Differential
• Non-zero skewness indicates
that exchange rate ups and
downs are not equally likely

• High interest rate currencies

tend to have negative skewness
of FX changes
Source: Brunnermeier, Nagel, Pedersen (2008),
Data, monthly, 1986-2006
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 Readings

• Next lecture:
– KOM, Chapter 15

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