Please enable JavaScript.
Coggle requires JavaScript to display documents.
Chap 6: International Parity Relationships and Forecasting Foreign…
Chap 6: International Parity Relationships and Forecasting Foreign Exchange Rates
Interest Rate Parity
Interest Rate Parity (IRP) is an arbitrage condition that must hold when international financial markets are in equilibrium.
Reasons for Deviations from Interest Rate Parity
Covered Interest Arbitrage
Interest Rate Parity Defined
IRP and Exchange Rate Determination
Purchasing Power Parity
Theory of purchasing power parity (PPP): The exchange rate between two currencies should
equal the ratio of the countries’ price levels: S($/pound)=P($)/P(pound)
changes in nominal exchange rates cause changes in the real exchange rates, affecting the international competitive positions of countries
q < 1: Competitiveness of the domestic country improves.
q > 1: Competitiveness of the domestic country deteriorates.
q = 1: Competitiveness of the domestic country unaltered.
Fisher Effects
The Fisher effect 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
Formally, the Fisher effect can be written for the United States as follows
E(-$) is the expected rate of U.S. inflation
i$ is the equilibrium expected nominal U.S. interest rate
P$ is the equilibrium expected “real” U.S. interest rate
If the Fisher effect holds in the U.S.
E=(i-p)/(1+p)
and the Fisher effect holds in U.K,
E=(i-p)/(1+p)
and if the real rates are the same in each country
p($) = p(pound)
then we get the International Fisher Effect (IFE): suggests that the nominal interest rate differential reflects the expected change in exchange rate.
Forecasting Exchange Rates
4.1 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]
In a sense, the random walk hypothesis suggests that today’s exchange rate is the best predictor of tomorrow’s exchange rate.
and
Ft = E[S(t+1)| It]
Predicting exchange rates using the efficient markets approach is affordable and is hard to beat.
4.2 Fundamental Approach
Involves econometrics to develop models that use a variety of explanatory variables.
s = α + β1 (m − m
) + β2 (v − v
) + β3 ( y
− y) + u
Generating forecasts using the fundamental approach would involve 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 into the estimated structural model to generate the exchange rate forecasts.
The downside is that fundamental models do not work any better than the forward rate model or the random walk model.
4.3 Technical Approach
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.”
4.4 Performance of the Forecasters
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.
Thus it is at odds with the EMH