# THEORIES OF FOREIGN EXCHANGE

International Parity Conditions

Exchange Rate Determination    What determines equilibrium relationships among exchange rates? International arbitrageur and the "Law of One-price" insure that risk adjusted expected rates of returns are approximately equal across countries. There are five key relationships between:      Spot rate Forward rate Inflation rate Interest rate Exchange rate .

Purchasing Power Parity   A unit of domestic currency should purchase the same amount of goods in the home country as it would of identical goods in a foreign country. Absolute form of PPP: “law of one price”: price of similar products to two countries should be equal when measured in a common currency. .

80 per \$ in indirect quote. The strictest version of PPP is not supported empirically. . The exchange rate must reflect this price relationship: e0 = Pd/Pf = \$10/€8 = \$1. but changes in relative inflation rates are related to changes in exchange rates. direct or American quote) Equivalent to €0.PPP Example    A bottle of wine costs €8 in Paris and \$10 in New York. European terms.25 per € (e0 = \$ per FC.

Relative form of PPP  Acknowledges market imperfections such as:   transport costs tariffs and quotas. .  Rate of change in the prices of products should be similar when measured in a common currency.

1667/1.1/Pf.Relative PPP .Example  Example: Suppose the price of wine in Paris increases to € 9 in one year implying an inflation of 12.S.1667 per € or €0.67% . The new exchange rate: e1 = Pd. while in the U.1 = \$10.2500 -1 = -6.5%.50 indicating an inflation rate of 5%.8571 per \$  What is the depreciation in the value of €? 1. the price of wine increases to \$10.5/€9 = \$1.

PPP Relative PPP: e1 = Pd .0 P f .1 = Pd .0 x (1+  d ) (1+  f ) OR (1 +  d ) e1 = e0 x (1 +  f ) OR e1 (1+  d ) = e0 (1+  f ) Approximately: %Δe0 = πd .1 P f .πf .

supply increases  FC appreciates. Rationale: if πd > πf. supply decreases  demand for LC decreases. then:  domestic imports increase.PPP Implication   According to PPP. the currency of countries with high inflation rates should devalue relative to countries with low inflations rates. LC depreciates . foreign exports increase  demand for FC increases. domestic exports decrease  foreign imports decrease.

05 = \$1. while the Britain's expected rate of inflation is 5 percent. inflation rate is expected to be 3 percent for the coming year.50 × 1.Relative PPP Example   Suppose the U.03/1.47 per £ . What should be the £ spot rate in one year? 1.S.50 per £. The current exchange rate is \$1.

as expressed in the Fisher theorem: 1 + i = (1 + r*) (1 + π) Or (1+ i) 1 + r* = (1+  )  Approximately: i = r* + π and r* = i .II: Fisher Effect    Recall the relationship between nominal and real rates of interest.π .

Otherwise funds would flows from countries with low expected real rates of interest to countries with high expected real rates of interests (in the absence of segmented markets) Therefore: r*f = r*d OR if .πd .πf = id .Generalized Fisher Effect     Real rates of interest are equalized across countries through arbitrage.

Generalized Fisher Effect  More precisely: (1+ i d ) (1+ i f ) = (1+ d ) (1+ f )  OR (1+ i d ) (1+  d ) = (1+ i f ) (1+  f )  Approximately: id  i f   d   f .

From PPP: From GFE: e1 (1+  d ) = e0 (1+  f ) (1+ i d ) (1+  d ) = (1+ i f ) (1+  f ) Therefore: e1 (1+ i d ) = e0 (1+ i f ) .III. International Fisher Effect Combines the generalized Fisher effect to show the relationship between nominal interest rates and currency exchange rates.

IFE Implications    Currencies with low interest rates would appreciate with respect to currencies with high interest rates.10 = \$0. Example: Interest rate in U. is 4%.5% .04/1. If the current SF spot rate is \$0.80 × 1.S.7564 per SF Or SF depreciates about 5. while interest rate in Switzerland is 10%.80. A long-run tendency for interest rates differentials to offset exchange rate changes has been demonstrated empirically. what should be the SF spot rate one year from now? \$0.

Recent work has demonstrated the existence of a slight risk premium.IV. Forward Rates and Expected Future Spot Rates     Early studies indicated forward exchange rates to be unbiased predictor of future spot exchange rates. Therefore. This equality captures the relationship between forward and spot rates. it is fair to assume that the future spot rates would equal forwards rates. f1 = E[e1] Then the forward rate premium or discount unbiasedly reflects potential gains to be realized from the purchase or sale of forward currencies. however. The premium. changes signs. .

Interest Rate Parity  Substituting f1 = E[e1] in the IFE equation: e1 (1+ i d ) = e0 (1+ i f ) (1+ i d ) = e0 (1+ i f ) f1 .V.

and 10% in Switzerland.80 = -2. arbitrage is possible.5% = 5%  Therefore. . The Swiss Franc spot rate is \$0. Id = 4% while If + discount = 10% . Is covered arbitrage possible? Forward discount on SF = (.Covered interest arbitrage   Suppose the interest rates are 4% in the U.5% for 180 days or -5% per year.7800.78 -.8000 and 180-day forward rate is \$0.80)/0.S.

250.020.020.78/SF Will receive 1.78/SF = \$1.000 3. Borrow \$1.000 @ 10% for 180 days: Will receive SF 1.750 -1.250.80 = SF 1.312.750 in 180 days 5.023.250. Loan plus Interest to be paid in 180 days = \$1.000.500 in forward market @180 forward rate \$0.000 2.023.Covered Arbitrage 1.500 × \$0.750 . Sell SF 1.750 from forward contract.000 in US @ 4% per year or 2% for half year.500 in 180 days 4.000. and pay-off loan Net profit form arbitrage: \$1.000 = \$3. After 180 days receive \$1.000 × (1+10%/2) = SF 1. Invest SF 1.312.312.023. Convert \$ to SF at the spot rate: \$1.000/0.

Interest Rates and Exchange Rates in Equilibrium Forward rate as an unbiased predictor (E) Forecast change in spot exchange rate +4% (yen strengthens) Purchasing power parity (A) Forward premium on foreign currency +4% (yen strengthens) International Fisher Effect (C) Forecast difference in rates of inflation -4% (less in Japan) Interest rate parity (D) Difference in nominal interest rates -4% (less in Japan) Fisher effect (B) .Prices.