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CHAP 6 International Parity Relationships and Forecasting Foreign…
CHAP 6
International Parity Relationships and Forecasting Foreign Exchange
Rates
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.
The Fisher effect can be written for the United States
The International Fisher Effect (IFE): suggests that the nominal interest rate differential reflects the expected change in exchange rate.
FEP states that any forward premium or
discount is equal to the expected change in the exchange rate.
When investors are risk-neutral, forward parity will hold as long as the foreign exchange market is
informationally efficient.
Interest Rate Parity
Covered Interest Arbitrage
the situation also gives rise to covered interest arbitrage
opportunities.
IRP and Exchange Rate
Determination
Being an arbitrage equilibrium condition involving the (spot) exchange rate, IRP has an immediate
implication for exchange rate determination.
◦ The interest rate available to an arbitrageur for borrowing
There may be bid-ask spreads to eCommerce
Fb/Sa < F/S
Governments sometimes restrict import and export of money through taxes or outright
bans.
Interest Rate Parity
An arbitrage condition that must hold when international financial
markets are in equilibrium.
Forecasting Exchange Rates
Performance of the Forecasters
Forecasting is difficult, especially with regard to the future.
Forecasters cannot do a better job of forecasting future exchange rates than the
forward rate.
Fundamental Approach
Generating forecasts using the fundamental approach
Step 1: Estimation of the structural model like Equation to determine the numerical values for the parameters such as α and β’s.
Step 3: Substituting the estimated values of the independent variables into the estimated structural model to generate the exchange rate forecasts.
Step 2: Estimation of future values of the independent variables like (m − m
), (v − v
), and (y* − y).
Involves econometrics to develop models that use a variety of explanatory variables.
s = α + β1(m − m
) + β2(v − v
) + β3( y* − y) + u
u = random error term, with mean zero.
α, β’s = model parameters.
s = natural logarithm of the spot exchange rate.
m − m* = natural logarithm of domestic/foreign money supply.
v − v
= natural logarithm of domestic/foreign velocity of money.
y
− y = natural logarithm of foreign/domestic output.
Efficient Markets Approach
the random walk hypothesis suggests that today’s exchange rate is the best
predictor of tomorrow’s exchange rate.
Predicting exchange rates using the efficient markets approach is affordable and is hard to
beat.
Technical Approach
Technical analysis first analyzes the past behavior of exchange rates for the purpose of identifying “patterns” and then projects them into the future to generate forecasts..
Clearly it is based upon the premise that history repeats itself.
Purchasing Power Parity
The exchange rate between two currencies should
equal the ratio of the countries’ price levels:
S($/£) = P$/P£
e = [ π$ - π£ / 1+π£ ] ~ π$ - π£
Real
exchange rates
q = 1+π$ / ( 1+e ) + ( 1+π£ )