Presentation on theme: "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."— Presentation transcript:
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 Big Mac in US costs $2.71. Implied PPP exchange rate
6 Economist, 4/ 2003
7 Relative PPP % change spot rate foreign currency US$/ yen Inf JAPAN - Inf US PPP line P
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… Why?
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 United States & Japan (1995 = 100) Real Effective Exchange Rate Indices
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 ($/FC), use (F-S)/S.
19 Interest Rate Parity (IRP) Interest rate parity:difference in national interest rates for securities of similar risk & maturity should be equal to opposite of forward rate discount/ premium for foreign currency. or
20 90 days S = SF /$ SF 1,480,000 Dollar money market $1,000,000$1,020,000 1.02 StartEnd i $ = 8 % per annum (2 % 90 days) Swiss franc money market SF 1,494,800 1.01 i SF = 4 % per annum (1 % 90 days) Interest Rate Parity (IRP) F 90 = SF /$ $1,019,993
21 Covered Interest Arbitrage (CIA) Because spot & forward markets are not in equilibrium, arbitrage exists. Covered interest arbitrage (CIA): invests in currency that offers higher return on covered basis.
days S =¥ /$ ¥ 106,000,000 Eurodollar rate = 8.00 % per annum Dollar money market $1,000,000$1,040,000 1.04 StartEnd Yen money market ¥ 108,120,000 1.02 Euroyen rate = 4.00 % per annum Covered Interest Arbitrage (CIA) F 180 = ¥ /$ Arbitrage Potential $1,044,638
23 Uncovered Interest Arbitrage (UIA) Uncovered interest arbitrage (UIA): investors borrow in currencies w/ low interest rates & convert proceeds into currencies w/ high interest rates. “Uncovered” because investor does not sell the currency forward.
24 Uncovered Interest Arbitrage (UIA): The Yen Carry Trade 360 days S =¥ /$ $ 83,333,333 Investors borrow yen at 0.40% per annum Japanese yen money market ¥ 10,000,000¥ 10,040,000 Repay StartEnd US dollar money market $ 87,500,000 1.05 Invest dollars at 5.00% per annum S 360 = ¥ /$ ¥ 10,500,000 Earn ¥ 460,000 Profit Then exchanges the yen proceeds for US dollars, investing in US dollar money markets for one year
25 Interest Rate Parity (IRP) & Equilibrium Percent difference between foreign (¥) and domestic ($) interest rates Percentage premium on foreign currency (¥) X U Z Y 4.83
26 Forward Rate - Unbiased Predictor? S1S1 Exchange rate Time t 2 t 3 t 4 t 1 S2S2 S3S3 S4S4 Error F2F2 F1F1 F3F3