13 views

Uploaded by scribdwt

- 107-120
- Bop
- GNP GDP Economic Growth
- Part III
- Eurostat - Statistics in focus 36/2008 - Comparative price levels for the Western Balkan region for 2006 - actual individual consumption
- Stochastic Crossovers
- Solución Punto 1
- PopEconDevDS
- Forex Risk Management
- The 1993 CIA World Factbook by United States. Central Intelligence Agency
- Business PCL I Fin Session 9&10 Techniques of Hedging
- Derivatives
- 3013238
- Forex market
- International Economics
- Currency derivatives trading in India survey presentation
- US-Japan Economic Relations. Significance, Prospects, And Policy Options
- Special Report by Epic Research 4 Febuary 2014
- Research article
- Role of Auto Sector in the Growth of Pak GDP

You are on page 1of 56

1) PPP

2) Fisher effect

3) Interest rate parity

1. Purchasing Power Parity

Prices and Exchange Rates

• If the identical product or service can be

sold in two different markets, and no

restrictions exist on the sale or

transportation costs of moving the product

between markets, the products price should

be the same in both markets.

• This is called the law of one price.

Prices and Exchange Rates

• A primary principle of competitive markets is that

prices will equalize across markets if frictions

(transportation costs) do not exist.

• Comparing prices then, would require only a

conversion from one currency to the other:

P$ x S = P¥

Where the product price in US dollars is (P$), the spot

exchange rate is (S) and the price in Yen is (P¥).

Prices and Exchange Rates

• If the law of one price were true for all goods and

services, the exchange rate could be found from any

individual set of prices.

• A weaker version of the law of one price is known as

Purchasing Power Parity (PPP). The PPP states that

the price of a basket of goods should be the same in

all markets. By comparing the prices of a basket of

goods denominated in different currencies, we could

determine the PPP exchange rate that should exist if

markets were efficient. This is the absolute version of

the PPP theory.

Purchasing Power Parity

P$

S($/£) = P

£

Prices and Exchange Rates

If the assumptions of the absolute version of the PPP

theory are relaxed a bit more, we observe what is

termed relative purchasing power parity (RPPP).

RPPP holds that PPP is not particularly helpful in

determining what the spot rate is today, but that

the relative change in prices between two

countries over a period of time determines the

change in the exchange rate over that period.

Prices and Exchange Rates

• More specifically, with regard to RPPP, if

the spot exchange rate between two

countries starts in equilibrium, any change

in the differential rate of inflation between

them tends to be offset over the long run by

an equal but opposite change in the spot

exchange rate.

Relative Purchasing Power Parity

• Relative PPP states that the rate of change in

the exchange rate is equal to the differences in

the rates of inflation:

S1 − S 0 (π $ – π £)

= e= ≈π $– π £

S0 (1 + π £ )

• If U.S. inflation is 5% and U.K. inflation is 8%,

the pound should depreciate by 2.78% or around

3%.

Evidence on PPP

• PPP probably doesn’t hold precisely in the real

world for a variety of reasons.

– Haircuts cost 10 times as much in the developed world

as in the developing world.

– AAA batteries, 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 the PPP.

• Relative PPP usually holds.

2. Interest Rate Parity

FX and Eurocurrency markets

Now Future

FC

FX and Eurocurrency markets

Now Future

$

spot exchange

market (S $/FC)

FC

FX and Eurocurrency markets

Now Future

$

forward

exchange

market (F $/FC)

FC

FX and Eurocurrency markets

Now Future

$

i (or i )

$

FC

FX and Eurocurrency markets

Now Future

i*

FC

FX and Eurocurrency markets

Now Future

i

$

S F

i*

FC

• FX and money markets create multiple

ways of moving money around:

– Across currencies

– Across time

• This mobility constrains relative prices in

the spot market, the forward market, and the

Eurocurrency markets in any two currencies

(interest rate parity)

Example: Two riskfree dollar investments

Investment #1: Eurodollar deposit

Now Future

i

$

Final Amount - 1 = i

Return =

Initial Amount

FC

Investment #1: Eurodollar deposit

Now Future

i

$ R1 = i

FC

Investment #2: Covered investment in

foreign currency

• Deposit in an interest-bearing Euro-FC account

• Contract now to convert principal + interest (in FC)

back to dollars @ forward rate F

Investment #2: Covered investment in foreign currency

1) Buy FC spot @ S $/FC

Now Future

$

S $/FC

FC

1/S units of FC

per $ invested

Investment #2: Covered investment in foreign currency

2) Invest @ Euro-rate i*

Now Future

$

S $/FC

i*

FC

1/S units of FC (1/S) (1+i*)

units of FC

Investment #2: Covered investment in foreign currency

3) Sell principal+interest at (precontracted) forward rate F

Now Future

$ (1/S) (1+i*)F

dollars

S $/FC F $/FC

i*

FC

1/S units of FC (1/S) (1+i*)

units of FC

Investment #2: Covered investment in foreign currency

Now Future

$ (1/S) (1+i*)F R2

dollars

S F

i*

FC

R2 = (F/S)(1+i*) - 1

Investment #2: Covered investment in foreign currency

Investment #1: Eurodollar investment

Now i Future

R1 = i

$ R2

S F

i*

FC

R2 = (F/S)(1+i*) - 1

Interest rate parity

• Since both investments have known

(riskfree) returns, those returns must be

identical: R1 = R2

• Reason: all markets are two-way; can

invest or borrow at R1 & R2

• A divergence between R1 & R2 creates a

money pump: borrow low, invest high

Example: R1 = 5%, R 2 = 6%

Now Future

FC

Example: R1 = 5%, R 2 = 6%

Now Future

R1 = 5%

$

FC

Example: R1 = 5%, R 2 = 6%

Now Future

R1 = 5%

$ R2 = 6%

FC

R2 = (F/S)(1+i*) - 1

Example: R1 = 5%, R 2 = 6%

Borrow @ R 1 , invest @ R2

Now Future

R1 = 5%

$ R2 = 6%

FC

R2 = (F/S)(1+i*) - 1 = 6%

Example #2: R 1 = 6%, R 2 = 5%

Now Future

R1 = 6%

$ R2 = 5%

FC

R2 = (F/S)(1+i*) - 1 = 5%

Example #2: R 1 = 6%, R 2 = 5%

Borrow FC with forward cover @ 5%, invest Euro-$ @6%

Now Future

R1 = 6%

$ R2 = 5%

FC

R2 = (F/S)(1+i*) - 1

Arbitrageurs eliminate divergences

between R1 and R2

R1 = R2

i = (F/S)(1 + i*) - 1

1 + i = (F/S)(1 + i*)

F = 1+i

S 1 + i*

Interest Rate Parity

F = 1+i

S 1 + i*

Caution: the formula depends on

how exchange rates are quoted

• Rule of thumb: the interest rate ordering

mimics the exchange rate quotations

• If exchange rates are quoted SF/$

(European convention), it’s a SF interest

rate in the numerator and a $ interest rate in

the denominator

Interest Rate Parity

F = 1+i

S 1 + i*

(for S and F in $/FC)

Interest Rate Parity

F = 1+i

S 1 + i*

(for S and F in $/FC)

SF/$

F = 1+i SF

SF/$

S 1+i $

General investment strategies

Lend $

$1 $(1+i)t

$F0,t (1+i*)t/S

Buy £ Deliver on

Short £ futures short £ futures

Lend £

£1/S £(1+i*)t/S

Practice problem

Assume the current $/£ exchange rate is 0.6 $/£ and 1-year futures exchange

rate is 0.61$/£. The risk-free interest rate in US is 4%. Find the risk-free

interest rate in UK.

Practice problem

Assume the current $/£ exchange rate is 0.6 $/£ and 1-year futures exchange

rate is 0.61$/£. The risk-free interest rate in US is 4%. Find the risk-free

interest rate in UK.

Solution:

F 0.61 1 + i 1.04

= = =

S 0.6 1 + i * 1 + i *

0.6

i * = 1.04 − 1 = 0.023 or 2.3%

0.61

Practice problem

year futures exchange rate is 0.61$/£. The risk-free

interest rates in US and UK are 4% and 3%

respectively. Is there an arbitrage opportunity?

Practice problem

Assume the current $/£ exchange rate is 0.6 $/£ and 1-year futures exchange rate is

0.61$/£. The risk-free interest rates in US and UK are 4% and 3% respectively. Is

there an arbitrage opportunity?

Solution:

Direct investment of $s gives you 4%

Indirect investment gives (1/0.6)*1.03*0.61-1 =0.0472 or 4.72%

Today: Borrow $1 at 4%, buy £(1/0.6), invest them at 3%, sell £(1/0.6)*1.03 futures

(note: your portfolio worth zero)

1-year from now: Collect £(1/0.6)*1.03 from your investment, sell £(1/0.6)*1.03 trough

previously bought futures contract to collect (1/0.6)*1.03*0.61 =$1.0472. Repay

your debt of 1.04. Profit = $0.0072

Question: why should we sell futures today? Why we cannot simply wait for one year to

sell our £s at a future spot rate?

Answer: because future spot rate will not be necessary equal to today’s futures rate.

Practice problem

Assume the current $/£ exchange rate is 0.6 $/£ and 1-year futures exchange

rate is 0.61$/£. The risk-free interest rates in US and UK are 4% and 2%

respectively. Is there an arbitrage opportunity?

Practice problem

Assume the current $/£ exchange rate is 0.6 $/£ and 1-year futures exchange

rate is 0.61$/£. The risk-free interest rates in US and UK are 4% and 2%

respectively. Is there an arbitrage opportunity?

Solution:

Direct investment of $s gives you 4%

Indirect investment gives (1/0.6)*1.02*0.61-1 =0.037 or 3.7%

Today: Buy $1 for £(1/0.6) and invest this $1 at 4%. Borrow, £(1/0.6) at 2%

and buy £(1/0.6)*1.02 futures

1-year from now: Collect $1.04 from your investment, buy £(1/0.6)*1.02

trough previously bought futures contract to repay your debt. Profit =

1.04-(1/0.6)*1.02*0.61= $0.003

Practice problem

Assume the current $/£ exchange rate is 1.7 $/£ and 1-year futures exchange

rate is 1.68$/£. The risk-free interest rates in US and UK are 4% and 6%

respectively. Is there an arbitrage opportunity?

Solution:

Direct investment of $s gives you 4%

Indirect investment gives (1/1.7)*1.06*1.68-1 =0.0475 or 4.75%

Today: Borrow $1, buy 1/1.7=£0.5882, invest it at 6% (so that you expect to

receive 1.06*(1/1.7)=£0.6235 one year from now) and sell futures

contract for £0.6235

1-year from now: Collect £0.6235 from your investment, sell £0.6235 trough

previously sold futures contract, receive 0.6235*1.68=$1.0475, repay you

debt of 1*1.04=$1.04. Profit = 1.0475-1.04= $0.0075

Practice problem

As in previous problem, assume the current $/£ exchange rate is 1.7 $/£ and 1-year

futures exchange rate is 1.68$/£. The risk-free interest rates at which you can invest

in US and UK are 4% and 6% respectively. However, since you do not have a very

good credit rating, you can borrow funds only at higher rates. Namely, you can

borrow $s at 5% and you can borrow £s at 7%. Is there an arbitrage opportunity?

Solution:

Try both directions

Direction 1: (borrow $s, invest £s)

Today: Borrow $1, buy 1/1.7=£0.5882, invest it at 6% (so that you expect to receive

1.06*(1/1.7)=£0.6235 one year from now) and sell futures contract for £0.6235

1-year from now: Collect £0.6235 from your investment, sell £0.6235 trough

previously sold futures contract, receive 0.6235*1.68=$1.0475, repay you debt of

1*1.04=$1.04. Profit = 1.0475-1.05= -$0.0025<0. No arbitrage this way

Today: Buy $1 for £(1/1.7) and invest this $1 at 4%. Borrow, £(1/1.7) at 7% and buy

£(1/1.7)*1.07=£0.6294 futures

1-year from now: Collect $1.04 from your investment, buy £0.6294 trough previously

bought futures contract to repay your debt. Profit = 1.04-(1/1.7)*1.07*1.68= 1.04-

1.0574=-$0.0174<0. No arbitrage this way as well

3. Fisher effect

The Fisher Effects

The nominal return i (nominal interest rate i) is the percentage change in the

amount of money you have.

The real return ρ (real interest rate ρ) is the percentage change in the amount of

stuff you can actually buy.

increase (decrease) in the interest rate in the country.

For Canada, the Fisher effect is written as:

1 + i$ = (1+ ρ $)(1 + E[π $]) = 1 + ρ $ + E[π $] + ρ $E[π $]

i$ = ρ $ + E(π $) + ρ $E[π $] ≈ ρ $ + E[π $]

Where

ρ $ is the equilibrium expected “real” Canadian interest rate

E[π $] is the expected rate of Canadian inflation

i$ is the equilibrium expected nominal Canadian interest rate

Expected Inflation

The Fisher effect implies that the expected inflation rate is approximated as the difference between the nominal and real interest rates in each country, i.e.

i$ = ρ $ + (1 + ρ $)E[π $] ≈ ρ $ + E[π $]

(i$ – ρ $)

E[π $] = ≈ i$ – ρ $

(1 + ρ $)

International Fisher Effect

• If the Fisher effect holds in Canada

1+i$ = (1+ ρ $)(1 + E[π $]) ≈ ρ $ + E[π $]

and the Fisher effect holds in Japan,

1+i¥ = (1+ ρ ¥ )(1 + E[π ¥]) ≈ ρ ¥ + E[π ¥]

and if the real rates are the same in each country (i.e.

ρ $ = ρ ¥ ), then, using RPPP, we get the International

Fisher Effect

S1 − S 0 (i$ – i¥)

E = E(e) = ≈ i$ – i¥

S0 (1 + i¥)

International Fisher Effect

(i$ – i¥)

E(e) =

(1 + i¥)

and if IRP also holds

F–S (i$ – i¥)

=

S (1 + i¥)

then forward expectation parity holds.

F–S

E(e) =

S

Forecasting Exchange Rates

Efficient Markets Approach

• Financial Markets are efficient if prices reflect

all available and relevant information.

• If this is so, exchange rates will only change

when new information arrives, thus:

Ft = E[St+1| It]

where Ft can be found from the Interest Rate

Parity

Fundamental Approach

• Involves econometrics to develop models that use a

variety of explanatory variables. This involves three

steps:

– step 1: Estimate the structural model using historical

data

Basic model:

S=α +β 1(m-m*)+β 2(y-y*)+ε

m=expected rate of grows of money

y=expected rate of real economic grows

– step 3: Use the model to develop forecasts.

Technical Approach

• Technical analysis looks for patterns in the

past behavior of exchange rates.

• Clearly it is based upon the premise that

history repeats itself.

• Thus it is at odds with the EMH

- 107-120Uploaded byQazi Mohsin Ali
- BopUploaded byHarshita Talreja
- GNP GDP Economic GrowthUploaded bylulughosh
- Part IIIUploaded bybengerson
- Eurostat - Statistics in focus 36/2008 - Comparative price levels for the Western Balkan region for 2006 - actual individual consumptionUploaded bydmaproiect
- Stochastic CrossoversUploaded byconstantine
- Solución Punto 1Uploaded bycarlos casas
- PopEconDevDSUploaded byDina Abd ElRasheed
- Forex Risk ManagementUploaded byNasir Uddin
- The 1993 CIA World Factbook by United States. Central Intelligence AgencyUploaded byGutenberg.org
- Business PCL I Fin Session 9&10 Techniques of HedgingUploaded byAashima Jain
- DerivativesUploaded byharshadave
- 3013238Uploaded byGauriGan
- Forex marketUploaded byvinni vone
- International EconomicsUploaded bycarolsaviapeters
- Currency derivatives trading in India survey presentationUploaded bySrikanth Kumar Konduri
- US-Japan Economic Relations. Significance, Prospects, And Policy OptionsUploaded byAngela Iriciuc
- Special Report by Epic Research 4 Febuary 2014Uploaded byEpicresearch
- Research articleUploaded byBrendan Lanza
- Role of Auto Sector in the Growth of Pak GDPUploaded byatique0928288
- Historical Rates IDR to MXN Marcho29 - May28Uploaded byFrancisco J Lopez
- School of Pipsology's Skinny on Forex TradingUploaded byBabyPips.com
- Derivative Report 28 August 2014Uploaded byStock Tips provider in India
- 8Uploaded byM-Faheem Aslam
- Presentation 2: Options Futures and Other Derivatives Hull Pretince HallUploaded byYolibi Khun
- Ogilvy Velocity MarketsUploaded byemailrobertguy
- The Effect of Global Liquidity on Macroeconomic ParametersUploaded byeditoraess
- Financial StabilityUploaded byrahulais
- Commitment of Traders Update 24Nov09Uploaded byAndysTechnicals
- 3012138Uploaded byGauriGan

- LicenseUploaded byanon-444297
- A USB MonitorUploaded byscribdwt
- Standard Budget EnUploaded byscribdwt
- Presentation HAVE April 2007Uploaded byscribdwt
- ELG5191 Design of Distributed System Software ChapterUploaded byscribdwt
- ELG5191 Design of Distributed System Software ChapterUploaded byscribdwt
- EZilla GroupUploaded byscribdwt
- EZilla GroupUploaded byscribdwt
- Installation GuideUploaded byscribdwt
- Installation GuideUploaded byscribdwt
- QoS OTTAWA Seminaire v2Uploaded byscribdwt
- Web-Based Mapping of Real-Time GIS DataUploaded byscribdwt
- Gis Spatial Data StructuresUploaded byscribdwt
- ELG5191 Design of Distributed System Software Chapter8 SOAP With AttachmentsUploaded byscribdwt
- Intern Finance Ch00 F2008Uploaded byscribdwt
- Search TreesUploaded byscribdwt
- A 3Uploaded byscribdwt
- QoS for IP (2)Uploaded byscribdwt
- ADM3305 Final Exam ReviewUploaded byscribdwt
- ADM 2350 Winter 2009 Assign 1Uploaded byscribdwt
- Apache Wink User GuideUploaded byscribdwt
- Practice Quiz3Uploaded byscribdwt

- Derivative NoteUploaded byShreyans Jain
- Suggested Answer P - 13 CMA FinalUploaded bychatur8407
- (Amit Kr. Jha) Mutual Fund Simplified ProjectUploaded bySanchit Jain
- Commodity Market QuestionnaireUploaded byarjunmba119624
- Level 3 1999 ExamUploaded byBalu Mahindra
- Time Series MomentumUploaded bypercysearch
- International Financial Management 6e Eun Resnick Chap001Uploaded byKatie Vo
- SECP Annual Report 2016 for CD HD-ilovepdf-compressed.compressedUploaded byMujawir Hussain
- Update2Uploaded byapi-27370939
- Unit Plan May 2011Uploaded byCheiThai Lee
- Tutorial 1.Questions(1)Uploaded byabcsing
- Futures trading derivativesUploaded byaanu1234
- Derivatives Markets Ppt MBAUploaded byBabasab Patil (Karrisatte)
- White Sugar Futures and Options Summary 2011-11globalderivativesUploaded byasianetix
- My notes P3Uploaded byrahul271188
- OGE Virtual Currency Reporting RequirementsUploaded byFedSmith Inc.
- fabozzi_BMAS9_IM_30.docxUploaded byasdasd
- New Microsoft Office Word DocumentUploaded byKhushboo Agrawal
- Dorab Mistry_Paper_GAPKI Conference 2012 at BaliUploaded byIbrahim Sjah Padu
- AlgoExplanationUploaded byVikas Mehta
- MPRA Paper 13074 DerivativesUploaded byanashj2
- ucla math 174EUploaded byHoang Trung Nguyen
- Chapter 20Uploaded bysdfklmjsdlklskfjd
- Trading_Grains_For_a_Living.pdfUploaded bysankha80
- Chapter 1 Overview of DerivativesUploaded bylelouch
- Udemy Python Financial Analysis SlidesUploaded byWang Shenghao
- The Ultimate Guide to Buying GoldUploaded byipins
- EnglismcxhUploaded byChetan Dave
- Commodity Derivatives ProjectUploaded bydesaikeyur
- New Age Finance Careers METUploaded byAnkit Verma