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CHAP 6: International Parity Relationships and Forecasting Foreign…
CHAP 6: International Parity Relationships and Forecasting Foreign Exchange
Rates
Interest Rate Parity
Covered Interest Arbitrage
When IRP doesn’t hold, the situation also gives rise to covered interest arbitrage opportunities.
borrowed at one interest rate and simultaneously lent at another interest rate, with exchange risk fully covered via forward hedging.
borrow in the United States
Following
interest rate will rise in the United States
interest rate will fall in the U.K.
pound will appreciate in the spot market
pound will depreciate in the forward market
lend in the U.K
buy the pound spot
sell the
pound forward
Interest Rate Parity and Exchange Rate Determination
IRP has an immediate implication for exchange rate determination.
the spot exchange rate depends on relative interest rates.
All else equal, an increase in the U.S. interest rate will lead to a higher foreign exchange value of the dollar.
can be viewed as the expected future spot exchange rate
Currency Carry Trade
uncovered interest rate parity
buying a high-yielding currency and funding it
with a low-yielding currency, without any hedging.
risky investment, especially when the exchange rate is volatile.
Reasons for Deviations from Interest Rate Parity
IRP may not hold precisely all the
time, especially over short periods.
transaction costs
The interest rate available to an arbitrageur for borrowing may exceed the rate he can lend at
capital controls
governments sometimes restrict capital
flows, inbound and/or outbound.
Definition
arbitrage condition that must hold when international
financial markets are in equilibrium.
If you invest $1 domestically at the U.S. interest rate (i$), the maturity value in one year will be
IRP can be derived by constructing an arbitrage portfolio
no net investment
no risk,
should not generate any net cash flow in equilibrium
net cash flow at the
time of investment is zero.
net cash flow on the maturity date is known with certainty.
Purchasing Power Parity
PPP Deviations and the Real Exchange Rate
Purchasing Power Parity (PPP)
define
the exchange rate
between currencies
two countries
equal to the ratio of the countries’ price levels
the dollar price of the standard consumption basket in the United States
the pound price of the same basket in the United Kingdom
S
the dollar price of one pound
the
absolute version of PPP
the PPP relationship is presented in the “rate of change” form
the
relative version of PPP
e
is the rate of change in the exchange rate
π $and π £are the inflation rates in the United States and U.K
the Real
Exchange Rate
if there are deviations from PPP
changes in nominal exchange rates
cause changes in the real exchange rates
affecting
the international competitive positions of countries
affect countries’ trade balances.
(1 + e) = (1 + π $ )/(1 + π £ ), the real exchange rate will be unity, q = 1.
q = 1: Competitiveness of the domestic country unaltered.
q < 1: Competitiveness of the domestic country improves.
q > 1: Competitiveness of the domestic country deteriorates.
Evidence on Purchasing Power Parity
The Big Mac of the McDonald’s fast-food chain
almost every currency
is undervalued against the dollar
The result is that the greenback itself looks stronger
In Russia
a Big Mac costs 110 rubles ($1.65)
compared with $5.58 in America
the ruble is undervalued by 70% against the greenback
the local price of a Big Mac fell by 15 percent.
In some places this has been driven by shifts in exchange rates
the dollar towers over rich and poor alike
PPP is a poor predictor of exchange rates in the short-term
it stacks up better over long periods
analysis of data going back to 1986
currencies deemed undervalued
the Big Mac index tend to strengthen, on average, in the subsequent ten years
Fisher Effects
holds that an increase (decrease) in the expected inflation rate in a country will cause a proportionate increase (decrease) in the interest rate in the country.
ρ $denotes the equilibrium expected “real” interest rate in the United States
E(π$) is the expected rate of U.S. inflation
i$ is the equilibrium expected nominal U.S. interest rate
International Fisher Effect
the Fisher effect holds in the U.S.
the Fisher effect holds in U.K,
the real rates are the same in each country
the International Fisher Effect (IFE)
the nominal interest rate differential
reflects the expected change in exchange rate.
effect is combined with IRP,
obtain
forward expectations parity (FEP).
any forward premium or discount is equal to the expected change in the exchange rate
investors are risk-neutral
1 more item...
Exact Equilibrium Exchange Rate
Relationships
With the assumption of the same real interest rate, the Fisher effect (FE) implies that the interest rate differential is equal to the expected inflation rate differential.
If both purchasing power parity (PPP) and forward expectations parity (FEP) hold, then the forward exchange premium or discount will be equal to the expected inflation rate differential. The latter relationship is denoted by the forward-PPP, i.e., FPPP in the exhibit.
IFE stands for the international Fisher effect.
Forecasting Exchange Rates
Efficient Market Approach
Financial Markets
are efficient if prices reflect all available and relevant information.
news definition
the exchange rate will
change randomly over time
when new information arrives
random walk hypothesis
foreign exchange markets are efficient
current exchange
rate
reflected all relevant information
The efficient market hypothesis (EMH),
Professor Eugene Fama
Nobel Prize in Economics in 2013
has strong implications for forecasting
Fundamental Approach
exchange rate forecasting
uses various models
the monetary approach
three explanatory variables
(i) relative money supplies
(ii) relative velocity of monies
(iii) relative national outputs.
Generating forecasts
three steps
Step 1: Estimation of the structural model like Equation 6.18 to determine the numerical
values for the parameters such as α and β’s.
Step 2: Estimation of future values of the independent variables like (m − m
), (v − v
), and
(y* − y).
Step 3: Substituting the estimated values of the independent variables
three main difficulties
one has to forecast a set of independent variables to forecast the exchange rates
α and β are estimated using
historical data may change over time
the model itself can be wrong
Technical Approach
first analyzes
past behavior
exchange rates
purpose of
identifying “patterns”
future to generate forecasts..
Clearly it is based upon the premise that history repeats itself.
it is at odds with the EMH
two examples
technical analysis
the moving average crossover rule
the head-andshoulders pattern
Performance of the Forecasters
Forecasting is difficult,
regard to the future.
cannot do a better job
forecasting future exchange rates than the
forward rate.
“You can make more money selling financial advice than following it.”
