Exchange Rates vs. Interest Rates Sources of Potential Profit Prepared by: Branko Ðapić, Christian Helland, Jeong-Jun Lee, Wook-Jong Lee, Lizabeth Montaño, Walter Zevallos

Exchange rate: Price of one currency in terms of another, conventional way- home currency per foreign Price of one currency in terms of another, conventional way- home currency per foreign A depreciation (appreciation) of a country’s currency makes its goods cheaper (more expensive) for foreigners, and makes foreign goods more expensive (cheaper) for domestic residents. A depreciation (appreciation) of a country’s currency makes its goods cheaper (more expensive) for foreigners, and makes foreign goods more expensive (cheaper) for domestic residents. Key players in the market: commercial banks, corporations, nonbank financial institutions (insurance companies, pension funds), central banks. Key players in the market: commercial banks, corporations, nonbank financial institutions (insurance companies, pension funds), central banks.

Assumptions: Currently hold dollar denominated deposits Currently hold dollar denominated deposits Risk and liquidity is the same between currencies Risk and liquidity is the same between currencies Our Goal: Find the relationship between the interest rates and exchange rate Find the relationship between the interest rates and exchange rate Predict the near future movement so we can maximize our wealth Predict the near future movement so we can maximize our wealth

How is exchange rate determined? The Asset Approach – based upon “interest rate parity” The Asset Approach – based upon “interest rate parity” Monetary Approach – based upon “purchasing power parity” Monetary Approach – based upon “purchasing power parity” The key element > Expected Rate of Return Investors care about Real rate of return Real rate of return Risk Risk Liquidity Liquidity

The basic equilibrium condition in the foreign exchange market is interest parity. Uncovered interest parity R $ =R ¥ +(E e $/¥ -E $/¥ )/E $/¥ -Risk Premium R $ =R ¥ +(E e $/¥ -E $/¥ )/E $/¥ -Risk Premium Covered interest rate parity (risk-free) R $ =R ¥ +(F $/¥ -E $/¥ )/E $/¥

Historical Interest Rates & Historical Exchange Rates Historical Interest Rates & Historical Exchange Rates Dollar Yen Interest spread

Explaining the Spread (Dollar vs. Yen) Interest spread Change in Exchange rate Interest parity

Time Interest parity 0 Deposit in Foreign Currency Deposit in $US Negative Positive Intuition of the Model

ADF Test Statistic % Critical Value* % Critical Value % Critical Value *MacKinnon critical values for rejection of hypothesis of a unit root. Modeling the Yen:

Modeling Yen Parity:

Actual Upper Band (95% confidence) Actual Lower Band FAVORABLE $US REGION FAVORABLE YEN REGION

FORECASTING YEN PARITY:

Currency Rest of the Year Forecast Confidence Dollar vs. Yen Dollar Strongly favorable Dollar vs. Pound Can’t tell Indifferent Dollar vs. NOK NOK Slightly favorable Dollar vs. Franc Dollar Slightly favorable Conclusion

Questions?????

Modeling Yen with an ARMA(8,0) Backup slides (Exchange rate only)

Showing dYen to be a Stationary Series

Actual and Fitted Yen Model