2Agenda What is PPP & law of one price? What is exchange rate pass-through?How do interest rates & exchange rates link?Interest rate parity?What is covered interest arbitrage?What is uncovered interest arbitrage?
3Prices and Exchange Rates Law of one price:product’s price same in all marketsP$ S = P¥where spot exchange rate is S, yen per dollar.$
4Purchasing Power Parity & Law of One Price Absolute purchasing power parity:spot exchange rate is determined by relative prices of similar basket of goods.Relative purchasing power parity:Relative change in prices b/n countries determines change in forex rate.
5Absolute PPP: Big Mac Index Economist’s Big Mac PPP:Big Mac in China costs Yuan 9.90.Big Mac in US costs $2.71.Implied PPP exchange rate
7Relative PPP P PPP line % change spot rate foreign currency US$/ yen 24-5-4-1-3-2135-66% change spot rate foreign currencyUS$/ yenPInfJAPAN- InfUS
8But: PPP is not very accurate predictor… Why?PPP holds well over very long term…PPP holds better for countries w/ high inflation & underdeveloped capital markets…
9Is forex under-/over- valued? Use forex indices: trade-weighted bilateral exchange rates b/n the home country & trading partnersNominal exchange rate index : use actual exchange rates.Real effective exchange rate index indicates how the weighted average purchasing power of the currency has changed relative to some arbitrarily selected base period.
10Q: Can you tell when a currency is overvalued? Why the real exchange rate deviates from 100?
11Real Effective Exchange Rate Indices United States & Japan (1995 = 100)
12Exchange Rate Pass-Through Pass-through: change in prices of imported/exported goods when exchange rate changesBMW made in Germany spot rate US$ 35,000.where P$ is the price in US$, P€ is price in euros, S is spot rateEuro appreciates by 20%. But BMW is now only $40,000.Pass-through:Degree of pass-through: % / 20 % = 0.71 or 71 %€€/$
13Interest Rates & Exchange Rates? What is a fair nominal interest rate?Well, can ask a banker … or read Irvin Fisher…Fisher Effect: nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation.i = r + + r i is nominal rate, r is real rate, is expected rate of inflation.FE good for short maturity bonds, NOT long maturity ones.Why?
14International Fisher effect International Fisher effect (Fisher-open):spot exchange rate change equals opposite of interest rate differential.where S is indirect quote.Direct Quotes: US$/ Foreign Currency.Indirect Quotes: Foreign Currency / US$.Fisher-open not precise in short-term.Why?Should include forex risk premium.FC
15Forward Rate Forward Rate A forward rate: exchange rate quoted today for future date
16Forward Rate Spot rate SF 1.48/$ 90-day euro Swiss franc deposit rate 4% p.a.90-day euro-dollar deposit rate 8% p.a.
17Premium or discount?Forward premium or discount : % difference b/n spot & forward rates in annual percentage terms.For indirect quotes (FC per home currency, FC/$) thenSwiss franc sells premium 3.96% p. a.(takes 3.96% more US$ to get franc at 90-day forward rate)For direct quotes ($/FC), use (F-S)/S.
19Interest Rate Parity (IRP) Interest rate parity:difference in national interest rates for securities of similar risk & maturity should be equal to opposite of forward rate discount/ premium for foreign currency.or
20Interest Rate Parity (IRP) Dollar money market$1,000,000$1,020,000 1.02StartEndi $ = 8 % per annum(2 % 90 days)S = SF /$SF 1,480,000F90 = SF /$$1,019,99390 daysSwiss franc money marketSF 1,494,800 1.01i SF = 4 % per annum(1 % 90 days)
21Covered Interest Arbitrage (CIA) Because spot & forward markets are not in equilibrium, arbitrage exists.Covered interest arbitrage (CIA): invests in currency that offers higher return on covered basis.
23Uncovered Interest Arbitrage (UIA) Uncovered interest arbitrage (UIA): investors borrow in currencies w/ low interest rates & convert proceeds into currencies w/ high interest rates.“Uncovered” because investor does not sell the currency forward.
24Uncovered Interest Arbitrage (UIA): The Yen Carry Trade Investors borrow yen at 0.40% per annumJapanese yen money market¥ 10,000,000¥ 10,040,000 Repay 1.004StartEndS360 = ¥ /$¥ 10,500,000 Earn¥ ,000 ProfitThen exchangesthe yen proceedsfor US dollars,investing in USdollar moneymarkets forone yearS =¥ /$$ 83,333,333360 daysUS dollar money market$ 87,500,000 1.05Invest dollars at 5.00% per annum