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- . Foreign Exchange Rate Determination
- Parity Conditions In International Finance
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International Parity

Relationship (Shapiro, Chapter 4)

Purchasing power parity (PPP)

Fisher effect

International Fisher effect

Interest rate parity (IRP)

Unbiased forward rates

Covered interest arbitrage (CIA)

1

markets identical commodity (say, FX) sold

in different countries must sell for the same

price when their price is expressed in terms

of the same currency

and price inflation: when growth in a

countrys money supply is faster than

growth in output, price inflation is fueled,

which will lead to depreciation in currency of

that country.

2

Money supply and price inflation: when growth in a

countrys money supply is faster than growth in

output, price inflation is fueled, which will lead to

depreciation in currency of that country.

PPP holds that the expected change in the exchange

rate is due to the difference in expected inflation

rates in the respective countries.

(1 i )t

h

et e0

t

(1 i )

f

3

expected future spot rate in period t, ih and if the

expected home and foreign inflation rates,

respectively.

PPP states that the exchange rate between two

currencies will adjust to reflect the relative

inflation rates in the two countries. It is assumed

that the law of one price is valid.

Eg., the expected inflation rates for the US and

Australia in one year are 5% and 3%, respectively,

current spot exchange rate being

USD0.6000/AUD (or AUD1.6667/USD), what is

the expected future spot exchange rate in one

year?

4

(1 ih ) t

0 (1 i f ) t

et e

0.6

(1 0.05 )1

(1 0.03 )1

(2) When USD is the commodity currency:

(1 ih ) t

0 (1 i f ) t

et e

1

(

1

0

.

03

)

1

0.6 (1 0.05 )1

AUD1.6349 / USD

5

rate is higher, USD is expected to depreciate

from AUD1.6667/USD to AUD1.6349/USD.

Why?

Because American goods are relatively more

expensive, American will convert their USD to

get AUD so that they can buy goods in

Australia. The increases in the supply of

USD and the demand for AUD will drive up

the price of AUD. USD will continue to

depreciate until an equilibrium point is

reached (ie., AUD1.6349/USD in this case).

6

the country with higher inflation rate will

depreciate.

PPP is simple and easy to understand.

Empirical research shows that it does

not hold in reality, especially in the

short-run. If it does hold, it holds only in

the long-run

AUD should appreciate against USD by 2%

roughly (ie., e = 2% roughly).

Mathematically:

(1 ih )

(1 e)

(1 if )

(1 5%)

(1 3%)

1.0194

8

Real exchange rate is the spot rate adjusted for

relative price level changes since a base period.

Specifically,

(1 i f ) (1 iC )

'

e1 e1

or

(1 i )

(1 i )

h

'

e1

e1

1 ih

Where

0 to 1

1 i f is the foreign inflation rate from time

0 to 1

9

Given

Let

(1 i f ) (1 iC )

or

e1 (1 ih )

(1 iT )

'

e1

'

e1

1 e e

Let

(1 i f )

(1 e)(1 ih )

10

1. Competitiveness of domestic country in

international trade remains unchanged

If q < 1, competitiveness of domestic country

improves with currency depreciations

because domestic currency depreciated

more than required by PPP.

If q > 1, competitiveness of domestic

country deteriorates with currency

depreciations because domestic currency

depreciated less than required by PPP.

11

Fisher equation maintains that, for any given

currency, the nominal interest rate (r) will be

set by the market such that it covers

expected inflation rate (E(i)) and provides a

required real rate of return (real interest rate,

r*).

Roughly, nominal interest rate

= Real interest rate + Expected inflation rate

Mathematically,

1 + r = (1+r*)(1 + E(i))

12

If Fisher equation holds for both countries, A

and B, then

1 rB (1 r*)[1 E (iB )]

We have

1 rA

1 rB

(1 r *) [1 E ( i A )]

(1 r *) [1 E ( iB )]

13

in the market. Real interest rates are

nominal rates adjusted for expected

inflation

(C) International Fisher Effect

Tthe expected change in spot exchange

rate between two currencies is the

difference in the interest rates between

the two currencies.

14

countries, then

1 rA

1 rB

[1 E ( i A )]

[1 E ( iB )]

Given PPP,

E ( S ) 1 E (i A )

S

1 E (iB )

we have,

E ( S ) 1 E (i A ) 1 rA

S

1 E (iB ) 1 r B

15

Since forward rate is an unbiased predictor

for future spot rate, we have

f

s

E (s)

s

1i A 1 rT

f

s 1iB 1 rC

16

The IRP states that relative interest rates

between two countries, say UK and USA,

determine the relativity between the forward

exchange rate (f) and spot exchange rate

(s):

1 rh

1 rT

f

or

s 1 rC

1 r f

17

exchange rates, returns from investing in the

two currencies must be equal, otherwise

there will be arbitrage opportunity.

Arbitrage activity will ensure that the exchange

rates will go back to the equilibrium. This is

the so-called law of one price.

The IRP relationship: the higher (lower)

interest rate currency will sell at a discount

(premium) in the forward markets.

18

works through the international Fisher

theorem.

PPP: The currency with higher inflation

will depreciate

Fisher Theorem: The currency with

higher inflation rate will have higher

nominal interest rate. Therefore:

IRP: The currency with higher interest

rate will have a lower forward rate.

19

It is a very simple model that assumes exchange

rate is only determined by relative inflation rates of

the two countries. There are many other factors

that help to determine exchange rate.

IRP is useful because it provides an equation to

allow forward rates to be calculated. All banks

use IRP to calculate forward rates.

For the forward rates that banks quote, banks can

hedge their FX position using IRP.

20

Direct FX rates: d/f (domestic/foreign currency)

FRP

IFE

DFE

(1 + rh)

(1 + r*h)(1 + ih)

F = E[S] = S

=

f

(1 + r ) S (1 + r*f) (1 + if)

IRP

(1 + ih)

= S (1 + if)

RPPP

IFEC

FRP: Forward Rate Parity

DFE: Domestic Fisher Effect

IFE: International Fisher Effect

RPPP: Relative Purchasing Power Parity

IFEC: International Fisher Relation Corollary (equality of real returns)

21

Indirect FX rates: f/d (foreign/domestic currency)

FRP

IFE

DFE

(1 + if)

(1 +i*f)(1 + pf)

F = E[S] = S (1 + id) = S

(1 +i*d)(1 + pd)

IRP

RPPP

(1 + pf)

= S (1 + pd)

IFEC

FRP: Forward Rate Parity

DFE: Domestic Fisher Effect

IFE: International Fisher Effect

RPPP: Relative Purchasing Power Parity

IFEC: International Fisher Effect Corollary (equality of real returns)

22

From IRP:

(1 rT )

f s

(1 rC )

GBP are 7.1% and 11.56% p.a. respectively

and the spot exchange rate is

USD1.2500/GBP, calculate the 1-year forward

rate.

(1 0.071)

f 1.25 (1 0.1156) 1.2000

The equilibrium forward rate is USD1.2000/GBP.

23

a covered interest arbitrage (CIA)

opportunity.

For example, what if the bank quotes you the

1-year forward rate as USD1.1950/GBP in

the above example?

What would you do? Conduct a secret CIA

operation!!!

24

(1 0.071)

1.2500 (1 0.1156)

1.2000 1.1950

The calculated f is higher than the quoted f. To

conduct the CIA operation, one would buy

low and sell high in order to make an

arbitrage profit, ie., sell GBP spot and buy

GBP forward.

25

1. Borrow GBP at 11.56% pa for one year

and sell it (ie., buy USD) at

USD1.2500/GBP

2. Invest the USD to earn 7.1% for one year

3. Sell the USD 1-year forward (ie., buy

GBP forward) at USD1.1950.

26

Calculation:

Borrow GBP1 at 11.56% for one year and you

payback GBP1(1+0.1156) = GBP1.1156

Convert into USD at 1.2500, invest the sum to

earn 7.1% pa for one year, you get

USD1.2500(1+ 0.071) = USD1.33875;

Sell USD1.33875 1-year forward at 1.1950,

you get GBP1.1203.

Arbitrage profit = 1.1203 1.1156 =

GBP0.0047.

Arbitrage profit is GBP0.0047 per GBP in one

year.

27

interest rate: 5% pa, GBP interest rate 8% pa,

Spot exchange rate: USD1.5000/GBP, Oneyear forward: USD1.4800/GBP

rUSD

F

(1 rUSD ) (1 rGBP )

S

1.48

(1.08) 1.0656

1.50

28

The effective interest rate of USD is still lower that that

of GBP at 8%, one should borrow USD at 5% and

lend in GBP to arbitrage.

This approach is easier, but it is better if you

understand the following approach in (b)

(b) Alternately, calculate the forward rate:

1.50(1.05) / 1.08) 1.4583 1.48

So sell GBP forward (ie., buy GBP spot). To buy GBP,

one must borrow USD.

The two approaches would give the same answer. 29

Weighted Index in Australia, TWI)

Effective exchange rate, is a multilateral

exchange rate which is a weighted average of

exchange rates of home and foreign

currencies, with the weight for each foreign

country equal to its share in trade. It measures

the average price of a home good relative to

the average price of goods of trading partners,

using the share of trade with each country as

the weight for that country.

30

instrument used by economies to compare their

exchange rate against those of their major trading

partners. Those trading partners that constitute a

larger portion of an economy's exports and

imports receives a higher index.

complete comparison between one economy's

currency and other currencies it interacts with. It is

a much more comprehensive analysis than

comparing two currencies, for example, the

Australian dollar and the U.S. dollar.

31

rate is that if the index increases, the

purchasing power of that currency is higher

(the currency strengthened against those of

the country's or area's trading partners).

A lower index means that the currency

depreciated (devaluation) so that you need

more of that currency to pay for imports.

(See Wikipedia:

http://en.wikipedia.org/wiki/Exchange_rate)

32

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