Download presentation

Presentation is loading. Please wait.

1
**International Parity Conditions**

(or chapter 4)

2
**Agenda 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?

3
**Prices and Exchange Rates**

Law of one price: product’s price same in all markets P$ S = P¥ where spot exchange rate is S, yen per dollar. $

4
**Purchasing 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.

5
**Absolute 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

6
Economist, 4/ 2003

7
**Relative PPP P PPP line % change spot rate foreign currency US$/ yen**

2 4 -5 -4 -1 -3 -2 1 3 5 -6 6 % change spot rate foreign currency US$/ yen P InfJAPAN- InfUS

8
**But: 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…

9
**Is forex under-/over- valued?**

Use forex indices: trade-weighted bilateral exchange rates b/n the home country & trading partners Nominal 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.

10
**Q: Can you tell when a currency is overvalued?**

Why the real exchange rate deviates from 100?

11
**Real Effective Exchange Rate Indices**

United States & Japan (1995 = 100)

12
**Exchange Rate Pass-Through**

Pass-through: change in prices of imported/exported goods when exchange rate changes BMW made in Germany spot rate US$ 35,000. where P$ is the price in US$, P€ is price in euros, S is spot rate Euro appreciates by 20%. But BMW is now only $40,000. Pass-through: Degree of pass-through: % / 20 % = 0.71 or 71 % € €/$

13
**Interest 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?

14
**International 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

15
**Forward Rate Forward Rate**

A forward rate: exchange rate quoted today for future date

16
**Forward 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.

17
Premium or discount? Forward premium or discount : % difference b/n spot & forward rates in annual percentage terms. For indirect quotes (FC per home currency, FC/$) then Swiss franc sells premium 3.96% p. a. (takes 3.96% more US$ to get franc at 90-day forward rate) For direct quotes ($/FC), use (F-S)/S.

18
**Currency Yield Curve & Forwards**

Months Interest yield 2 4 1 3 5 6 1.0 % 3.0 % 4.0 % 5.0 % 6.0 % 2.0 % Euro yield curve Forward premium on low interest rate currrency Eurodollar yield curve

19
**Interest 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

20
**Interest Rate Parity (IRP)**

Dollar money market $1,000,000 $1,020,000 1.02 Start End i $ = 8 % per annum (2 % 90 days) S = SF /$ SF 1,480,000 F90 = SF /$ $1,019,993 90 days Swiss franc money market SF 1,494,800 1.01 i SF = 4 % per annum (1 % 90 days)

21
**Covered 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.

22
**Covered Interest Arbitrage (CIA)**

Eurodollar rate = 8.00 % per annum Dollar money market $1,000,000 $1,040,000 1.04 Start End F180 = ¥ /$ Arbitrage Potential $1,044,638 S =¥ /$ ¥ 106,000,000 180 days Yen money market ¥ 108,120,000 1.02 Euroyen rate = 4.00 % per annum

23
**Uncovered 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.

24
**Uncovered Interest Arbitrage (UIA): The Yen Carry Trade**

Investors borrow yen at 0.40% per annum Japanese yen money market ¥ 10,000,000 ¥ 10,040,000 Repay 1.004 Start End S360 = ¥ /$ ¥ 10,500,000 Earn ¥ ,000 Profit Then exchanges the yen proceeds for US dollars, investing in US dollar money markets for one year S =¥ /$ $ 83,333,333 360 days US dollar money market $ 87,500,000 1.05 Invest dollars at 5.00% per annum

25
**Interest Rate Parity (IRP) & Equilibrium**

4 3 2 Percentage premium on foreign currency (¥) 1 4.83 -6 -5 -4 -3 -2 -1 1 2 3 4 5 6 -1 -2 -3 Percent difference between foreign (¥) and domestic ($) interest rates X U -4 Y Z

26
**Forward Rate - Unbiased Predictor?**

Exchange rate Time S2 Error F2 S3 S4 F1 Error S1 F3 Error t 2 t 3 t 4 t 1

Similar presentations

OK

Exchange Rates and the Foreign Exchange Market: An Asset Approach

Exchange Rates and the Foreign Exchange Market: An Asset Approach

© 2018 SlidePlayer.com Inc.

All rights reserved.

Ads by Google

Seminar ppt on power electronics Ppt on disposal of plastic waste Ppt on job evaluation system Ppt on chapter 12 electricity Ppt on world environment day posters Ppt on food processing technology Ppt on mars one finalists Ppt on marie curie's discoveries Ppt on causes of 1857 revolt leaders Ppt on networking related topics about information