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McGraw-Hill/Irwin
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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Rate Parity Defined Covered Interest Arbitrage Interest Rate Parity & Exchange Rate Determination Reasons for Deviations from Interest Rate Parity
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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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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)
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$1,000 S$/
IRP
Step 2: Invest those pounds at i Future Value =
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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
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1 + i$ F$/ = 1 + i S$/
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upon how you quote the exchange rate (as $ per or per $) we have:
1 + i F/$ = 1 + i$ S/$
or
1 + i$ F$/ = 1 + i S$/
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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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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)
$1,030
F360($/) = $2.01/
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Arbitrage Strategy I
If F360($/) > $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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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
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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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 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/) = $201M in one year. b) Form a money market hedge as shown below.
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97,570,494.68 =
100,000,000 1.0249
How many dollars will it take to acquire 97,570,494.68 at the start of the year if S($/) = $2/? $2.00 $195,140,989.36 = 97,570,494.68 1.00
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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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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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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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y $x = S($/) (1+ i )T
$x
$x(1 + i$)T T
0
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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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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
f180,v$
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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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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($/)
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IRP
Step 3
b 1m S0($/)
lend at i$l
l 1m Sb($/) (1+i$) 0
IRP
Fa ($/) = 1
b S0($/)(1+i$l)
(1+ib) = $1.4065/
the dealer sets the ask price above the bid recall that this difference is his expected profit. But the prices on the last two slides are the prices of indifference for the customer NOT the dealer. At these forward bid and ask prices the customer is indifferent between a forward market hedge 6-35
Normally
Dealer buys foreign currency at the bid price Dealer sells foreign currency at the ask price Dealer borrows (from customer) at the lending rates i$l = 4.5% and i = 5.0% l b b Dealer lends to his customer at the borrowing ratei$ = 5.0%, i = 5.5%.
Spot
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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
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
Power Parity and Exchange Rate Determination PPP Deviations and the Real Exchange Rate Evidence on PPP
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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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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)
$1.23 1.00
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F($/) = S($/)
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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PPP
F($/) 1 + $ = S($/) 1 + =
IRP
1 + i$ F($/) = 1 + i S($/)
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F($/) 1 + $ = S($/) 1 +
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$ 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
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(i$ i)
FS S
FRPPP
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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E(1 + ) 1 + i = 1 + i$ E(1 + $)
E(1 + ) 1 + i = 1 + i$ E(1 + $) and if IRP also holds 1 + i F/$ = 1 + i$ S/$ F/$ E(1 + ) then forward rate PPP holds: = S/$ E(1 + $)
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IFE
FEP
1 + i 1 + i$
F / $ S /$
FRPPP
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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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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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