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INTERNATIONAL FINANCIAL MANAGEMENT

Fifth Edition EUN / RESNICK

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights res

International Parity Relationships and Forecasting Foreign Exchange Rates


Chapter Objective:

Chapter Six

This chapter examines several key international parity relationships, such as interest rate parity and purchasing power parity.

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Chapter Outline
Interest Rate Parity Interest Rate Parity Purchasing Power Parity Covered Interest Arbitrage Purchasing Power Parity The FisherExchange Rate Real Exchange Rate IRP and Effects the Determination PPP Deviations and The Fisher Effects

Evidence Exchange Rates ForecastingonExchange Power Parity Forecasting Purchasing Rates Purchasing Power Parity The Fisher Effects Efficient Market Approach The Fisher Effects Forecasting Exchange Rates Fundamental Approach ForecastingApproach Technical Exchange Rates Performance of the Forecasters
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Reasons for Deviations from IRP

Interest Rate Parity


Interest

Rate Parity Defined Covered Interest Arbitrage Interest Rate Parity & Exchange Rate Determination Reasons for Deviations from Interest Rate Parity

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Interest Rate Parity Defined


IRP

is an no arbitrage condition. If IRP did not hold, then it would be possible for an astute trader to make unlimited amounts of money exploiting the arbitrage opportunity. Since we dont typically observe persistent arbitrage conditions, we can safely assume that IRP holds. almost all of the time!

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Interest Rate Parity Carefully Defined


Consider alternative one-year investments for $100,000: 1. Invest in the U.S. at i$. Future value = $100,000 (1 + i$)
2.

Trade your $ for at the spot rate, invest $100,000/S$/ in Britain at i while eliminating any exchange rate risk by selling the future value of the British investment forward.

Since these investments have the same risk, they must have the same future value (otherwise an arbitrage would exist)

F$/ Future value = $100,000(1 + i) S$/

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

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

Alternative 2: Send your $ on a round trip to Britain $1,000

$1,000 S$/

IRP
Step 2: Invest those pounds at i Future Value =

Alternative 1: invest $1,000 at i$

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Since both of these investments have the same risk, they must have the same future valueotherwise an arbitrage would exist

IRP

$1,000 (1+ i) F$/ $1,000(1 + i$) = S$/

Step 3: repatriate future value to the U.S.A.

$1,000 (1+ i) S$/

Interest Rate Parity Defined


The

scale of the project is unimportant

$1,000 (1+ i ) F $1,000(1 + i$) = $/ S$/ F$/ (1 + i$) = S$/ (1+ i)

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Interest Rate Parity Defined


Formally,

1 + i$ F$/ = 1 + i S$/

IRP is sometimes approximated as i$ i F S S

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Interest Rate Parity Carefully Defined


Depending

upon how you quote the exchange rate (as $ per or per $) we have:

1 + i F/$ = 1 + i$ S/$

or

1 + i$ F$/ = 1 + i S$/

so be a bit careful about that.

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Interest Rate Parity Carefully Defined


No

matter how you quote the exchange rate ($ per or per $) to find a forward rate, increase the dollars by the dollar rate and the foreign currency by the foreign currency rate:
or

1 + i F/$ = S/$ 1 + i$

1 + i$ F$/ = S$/ 1 + i

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be carefulits easy to get this wrong.

IRP and Covered Interest Arbitrage


If IRP failed to hold, an arbitrage would exist. Its easiest to see this in the form of an example. Consider the following set of foreign and domestic interest rates and spot and forward exchange rates.
Spot exchange rate 360-day forward rate U.S. discount rate British discount rate
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S($/) = $2.0000/ F360($/) = $2.0100/ i$ = 3.00% i = 2.49%

IRP and Covered Interest Arbitrage


A trader with $1,000 could invest in the U.S. at 3.00%, in one year his investment will be worth $1,030 = $1,000 (1+ i$) = $1,000 (1.03) Alternatively, this trader could 1. Exchange $1,000 for 500 at the prevailing spot rate, 2. Invest 500 for one year at i = 2.49%; earn 512.45
3.

Translate 512.45 back into dollars at the forward rate F360($/ ) = $2.01/, the 512.45 will be worth $1,030.

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Alternative 2:
buy pounds 1 500 = $1,000 $2.00 $1,000 500

Arbitrage I

Step 2: Invest 500 at i = 2.49% 512.45 In one year 500 will be worth Step 3: repatriate 512.45 = to the U.S.A. at 500 (1+ i)

Alternative 1: invest $1,000 at 3% FV = $1,030

$1,030

F360($/) = $2.01/

F(360) $1,030 = 512.45 1

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Interest Rate Parity & Exchange Rate Determination


According to IRP only one 360-day forward rate, F360($/), can exist. It must be the case that F360($/) = $2.01/ Why? If F360($/) $2.01/, an astute trader could make money with one of the following strategies:
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Arbitrage Strategy I
If F360($/) > $2.01/ i. Borrow $1,000 at t = 0 at i$ = 3%. ii. Exchange $1,000 for 500 at the prevailing spot rate, (note that 500 = $1,000 $2/) invest 500 at 2.49% (i) for one year to achieve 512.45 iii. Translate 512.45 back into dollars, if F360($/) > $2.01/, then 512.45 will be more than enough to repay your debt of $1,030.
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Step 2: buy pounds 1 500 = $1,000 $2.00 $1,000

500

Arbitrage I

Step 1: borrow $1,000 Step 5: Repay your dollar loan with $1,030.

Step 3: Invest 500 at i = 2.49% 512.45 In one year 500 will be worth 512.45 = 500 (1+ i) Step 4: repatriate to the U.S.A. F(360) $1,030 < 512.45 1

More than $1,030

If F(360) > $2.01/ , 512.45 will be more than enough to repay 6-17 your dollar obligation of $1,030. The excess is your profit.

Arbitrage Strategy II
If F360($/) < $2.01/ i. Borrow 500 at t = 0 at i= 2.49% . ii. Exchange 500 for $1,000 at the prevailing spot rate, invest $1,000 at 3% for one year to achieve $1,030. iii. Translate $1,030 back into pounds, if F360($/) < $2.01/, then $1,030 will be more than enough to repay your debt of 512.45.
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Step 2: buy dollars $2.00 $1,000 = 500 1 $1,000

500

Arbitrage II
Step 1: borrow 500

Step 5: Repay More Step 3: your pound loan than Invest $1,000 with 512.45 . 512.45 at i$ = 3% Step 4: repatriate to the U.K. In one year $1,000 F(360) will be worth $1,030 > 512.45 $1,030 1 If F(360) < $2.01/ , $1,030 will be more than enough to repay your dollar obligation of 512.45. Keep the rest as profit.

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IRP and Hedging Currency Risk


You are a U.S. importer of British woolens and have just ordered next years inventory. Payment of 100M is due in one year.
Spot exchange rate 360-day forward rate U.S. discount rate British discount rate S($/) = $2.00/ F360($/) = $2.01/ i$ = 3.00% i = 2.49%

IRP implies that there are two ways that you fix the cash outflow to a certain U.S. dollar amount: a) Put yourself in a position that delivers 100M in one yeara long forward contract on the pound. You will pay (100M)($2.01/) = $201M in one year. b) Form a money market hedge as shown below.
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IRP and a Money Market Hedge


To form a money market hedge: 1. Borrow $195,140,989.36 in the U.S. (in one year you will owe $200,995,219.05). 2. Translate $195,140,989.36 into pounds at the spot rate S($/) = $2/ to receive 97,570,494.68 3. Invest 97,570,494.68 in the UK at i = 2.49% for one year. 4. In one year your investment will be worth 100 millionexactly enough to pay your supplier.
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Money Market Hedge


Where do the numbers come from? We owe our supplier 100 million in one yearso we know that we need to have an investment with a future value of 100 million. Since i = 2.49% we need to invest 97,570,494.68 at the start of the year.

97,570,494.68 =

100,000,000 1.0249

How many dollars will it take to acquire 97,570,494.68 at the start of the year if S($/) = $2/? $2.00 $195,140,989.36 = 97,570,494.68 1.00
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Money Market Hedge


This

is the same idea as covered interest arbitrage. To hedge a foreign currency payable, buy a bunch of that foreign currency today and sit on it.

Buy the present value of the foreign currency payable today. Invest that amount at the foreign rate. At maturity your investment will have grown enough to cover your foreign currency payable.

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Money Market Hedge: an Example


Suppose that the spot dollar-pound exchange rate is $2.00/ and i$ = 1% i = 4% 0 1 Step 1 Step 5 Order Inventory; agree to Redeem -denominated pay supplier 100 in 1 year. investment receive 100 million Step 2 Step 6 Borrow $192,307,692 at i$ = 1% ($192,307,692 = 96,153,846$2/) Pay supplier 100 million Step 3 100,000,000 Step 7 Buy 96,153,846 = Repay dollar loan with 1.04 at spot exchange rate. $194,230,769 Step 4 Invest 96,153,846 at i = 4%
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Another Money Market Hedge


A U.S.based importer of Italian bicycles

In one year owes 100,000 to an Italian supplier. The spot exchange rate is $1.50 = 1.00 The one-year interest rate in Italy is i = 4%

100,000 Can hedge this payable by buying 96,153.85 = 1.04 today and investing 96,153.85 at 4% in Italy for one year. At maturity, he will have 100,000 = 96,153.85 (1.04) $1.50 Dollar cost today = $144,230.77 = 96,153.85 1.00
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Another Money Market Hedge


With

this money market hedge, we have redenominated a one-year 100,000 payable into a $144,230,77 payable due today. If the U.S. interest rate is i$ = 3% we could borrow the $144,230,77 today and owe in one year
$148,557.69 = $ 144,230,77 (1.03) 100,000 T $148,557.69 = S($/) T (1+ i$) (1+ i)
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Generic Money Market Hedge: Step One


Suppose you want to hedge a payable in the amount of y with a maturity of T:
i. Borrow $x at t = 0 on a loan at a rate of i$ per year.

y $x = S($/) (1+ i )T

$x

Repay the loan in T years

$x(1 + i$)T T

0
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Generic Money Market Hedge: Step Two


y ii. Exchange the borrowed $x for (1+ i)T

at the prevailing spot rate.

y Invest at i for the maturity of the payable. T (1+ i) At maturity, you will owe a $x(1 + i$)T. Your British investments will have grown to y. This amount will service your payable and you will have no exposure to the pound.
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Generic Money Market Hedge


y 1. Calculate the present value of y at i (1+ i)T 2. Borrow the U.S. dollar value of receivable at the spot rate. 3. Exchange $x = S($/) 4. Invest y (1+ i)T for y (1+ i)T

y at i for T years. T (1+ i)

5. At maturity your pound sterling investment pays your receivable. 6. Repay your dollar-denominated loan with $x(1 + i$)T.
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Forward Premium
Its

just the interest rate differential implied by forward premium or discount. For example, suppose the is appreciating from S($/) = 1.25 to F180($/) = 1.30
The

forward premium is given by:

f180,v$
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F180($/) S($/) 360 $1.30 $1.25 = 180 = 2 = 0.08 S($/) $1.25

Reasons for Deviations from IRP


Transactions

Costs

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 Thus

(Fb/Sa)(1 + il) (1 + i b) 0
Capital

Controls

Governments sometimes restrict import and export of money through taxes or outright bans.

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Transactions Costs Example


Will

an arbitrageur facing the following prices be able to make money?


Borrowing Lending 4.50% 5.0% Spot 5.0% 5.5%

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


Bid $1.42 = 1.00 Ask $1.45 = 1,00 $1.445 = 1.00

Forward $1.415 = 1.00


a S0($/)(1+i$b) Fb($/) = 1 (1+il)

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b S0($/)(1+i$l) Fa($/) = 1 (1+ib)

Step 1 $1m Borrow $1m at i$b


b $1m(1+i$)

Step 2 b l $1m 1 (1+i) Fb ($/) = $1m(1+i$) 1 Buy at a S0($/) spot ask No arbitrage forward bid price (for customer):
a (1+i$b) S0($/)(1+i$b) Step 4 Fb ($/) = = 1 1 Sell at l (1+i) (1+il) a S0($/) forward = $1.4431/ bid l $1m 1 Step 3 invest at il $1m 1 (1+i) a a S0($/) S0($/)
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IRP

(All transactions at retail prices.)

Step 3
b 1m S0($/)

lend at i$l

l 1m Sb($/) (1+i$) 0

l a b 1m Sb($/) (1+i$) F1($/) = 1m(1+i) 0

IRP

No arbitrage forward ask price: Step 2 sell 1m at spot bid 1m


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Fa ($/) = 1

b S0($/)(1+i$l)

(1+ib) = $1.4065/

Step 4 buy at forward ask


b 1m(1+i)

Step 1borrow 1m at ib (All transactions at retail prices.)

Why This Seems Confusing


On

the last two slides we found no arbitrage

Forward bid prices of $1.4431/ and Forward ask prices of $1.4065/

the dealer sets the ask price above the bid recall that this difference is his expected profit. But the prices on the last two slides are the prices of indifference for the customer NOT the dealer. At these forward bid and ask prices the customer is indifferent between a forward market hedge 6-35

Normally

Setting Dealer Forward Bid and Ask


Dealer

stands ready to be on opposite side of every trade

Dealer buys foreign currency at the bid price Dealer sells foreign currency at the ask price Dealer borrows (from customer) at the lending rates i$l = 4.5% and i = 5.0% l b b Dealer lends to his customer at the borrowing ratei$ = 5.0%, i = 5.5%.

Borrowing 5.0% 5.5%

Lending 4.50% 5.0%

Bid $1.42 = 1.00

Ask $1.45 = 1.00 $1.445 = 1.00

Spot
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Forward $1.415 = 1.00

Setting Dealer Forward Bid Price


Our dealer is indifferent between buying euro today at spot bid price and buying euro in 1 year at forward bid price. $1m spot bid Invest at i$b
b $1m(1+i$)

He is willing to spend He is also willing to buy at $1m today and receive b S0($/)(1+i$b) 1 b F1($/) = $1m b S0($/) (1+ib) 1 b S0($/) Invest at ib $1m

$1m
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1 (1+ib ) b S0($/)

forward bid

Setting Dealer Forward Ask Price


Our dealer is indifferent between selling euro today at spot ask price and selling euro in 1 year at forward ask price.
b 1m S0($/)

Invest at i$b

b 1m S0($/) (1+ib ) $

He is willing to spend He is also willing to buy at 1m today and receive a S0($/)(1+i$b) b 1m S0($/) Fa ($/) = 1 (1+ib) Invest at ib

1m
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b 1m(1+i)

forward ask

spot ask

Purchasing Power Parity


Purchasing

Power Parity and Exchange Rate Determination PPP Deviations and the Real Exchange Rate Evidence on PPP

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Purchasing Power Parity and Exchange Rate Determination


The

exchange rate between two currencies should equal the ratio of the countries price levels: P$ S($/) = P

For example, if an ounce of gold costs $300 in the U.S. and 150 in the U.K., then the price of one pound in terms of dollars should be: P$ $300 S($/) = = = $2/ P 150

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Purchasing Power Parity and Exchange Rate Determination


Suppose

the spot exchange rate is $1.25 = 1.00 If the inflation rate in the U.S. is expected to be 3% in the next year and 5% in the euro zone, Then the expected exchange rate in one year should be $1.25(1.03) = 1.00(1.05)

F($/) =

$1.25(1.03) 1.00(1.05)

$1.23 1.00

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Purchasing Power Parity and Exchange Rate Determination

The euro will trade at a 1.90% discount in the forward market:

F($/) = S($/)

$1.25(1.03) 1.00(1.05) $1.25 1.00

1.03 1 + $ = 1.05 1 +

Relative PPP states that the rate of change in the exchange rate is equal to differences in the rates of inflationroughly 2%
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Purchasing Power Parity and Interest Rate Parity


Notice

that our two big equations today equal each other:

PPP
F($/) 1 + $ = S($/) 1 + =

IRP
1 + i$ F($/) = 1 + i S($/)

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Expected Rate of Change in Exchange Rate as Inflation Differential


We

could also reformulate our equations as inflation or interest rate differentials:

F($/) 1 + $ = S($/) 1 +

F($/) S($/) 1 + $ 1 + $ 1 + = 1= S($/) 1 + 1 + 1 + F($/) S($/) $ E(e) = $ = S($/) 1 +


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Expected Rate of Change in Exchange Rate as Interest Rate Differential


E(e) = F($/) S($/) = S($/) i$ i 1 + i i$ i

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Quick and Dirty Short Cut


Given

the difficulty in measuring expected inflation, managers often use

$ i$ i

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Evidence on PPP
PPP

probably doesnt 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. 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.

PPP-determined

exchange rates still provide a valuable benchmark.

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Approximate Equilibrium Exchange Rate Relationships


E(e)
IFE FEP PPP IRP FE E($ )
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(i$ i)

FS S
FRPPP

The Exact Fisher Effects

An increase (decrease) in the expected rate of inflation will cause a proportionate increase (decrease) in the interest rate in the country. For the U.S., the Fisher effect is written as: 1 + i$ = (1 + $ ) E(1 + $)

Where $ is the equilibrium expected real U.S. interest rate E($) is the expected rate of U.S. inflation i$ is the equilibrium expected nominal U.S. interest rate
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International Fisher Effect


If the Fisher effect holds in the U.S. 1 + i$ = (1 + $ ) E(1 + $) and the Fisher effect holds in Japan, 1 + i = (1 + ) E(1 + ) and if the real rates are the same in each country $ = then we get the International Fisher Effect:
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E(1 + ) 1 + i = 1 + i$ E(1 + $)

International Fisher Effect


If the International Fisher Effect holds,

E(1 + ) 1 + i = 1 + i$ E(1 + $) and if IRP also holds 1 + i F/$ = 1 + i$ S/$ F/$ E(1 + ) then forward rate PPP holds: = S/$ E(1 + $)
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Exact Equilibrium Exchange Rate Relationships


E (S / $ ) S /$
PPP IRP FE E(1 + ) E(1 + $)
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IFE

FEP

1 + i 1 + i$

F / $ S /$
FRPPP

Forecasting Exchange Rates


Efficient

Markets Approach Fundamental Approach Technical Approach Performance of the Forecasters

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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: St = E[St+1] and Ft = E[St+1| It] Predicting exchange rates using the efficient markets approach is affordable and is hard to beat.
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Fundamental Approach
Involves

econometrics to develop models that use a variety of explanatory variables. This involves three steps:

step 1: Estimate the structural model. step 2: Estimate future parameter values. step 3: Use the model to develop forecasts.

The

downside is that fundamental models do not work any better than the forward rate model or the random walk model.

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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

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Performance of the Forecasters


Forecasting

is difficult, especially with regard to

the future. As a whole, forecasters cannot do a better job of forecasting future exchange rates than the forward rate. The founder of Forbes Magazine once said: You can make more money selling financial advice than following it.
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