Lecture Notes Finance 3191 Finance 319 Lecture 10 Course Website u Galina Albert Schwartz Galina Albert Schwartz u Department of Finance u University of Michigan University of Michigan u Business School Business School

Lecture Notes Finance 3192 Plan of Today’s Lecture 1. Forward Premium & Forward Discount 2. Interest Rate Parity 3. Fisher Effect 4. International Fisher Effect 5. Empirical Evidence

Lecture Notes Finance 3193 Interest Rate Parity u Covered IRP is Uncovered + take u Uncovered IRP = International Fisher Effect u Covered IRP = Uncovered IRP + considerations of exchange rates (see Levich, p. 131), which is covering the exposure to exchange rate changes u Covered IRP is % forward premium= % interest differential

Lecture Notes Finance 3194 Fisher Effect u %nominal interest rate = % real interest rate + expected inflation: I = R + E(p)

Lecture Notes Finance 3195 Short run & long run u How long does it take to get to a long run equilibrium? u Depends on what we are looking –price of gasoline –stock market prices –government bonds prices –exchange rate [i.e. dollar price in terms of..]

Lecture Notes Finance 3196 Real Income u Levich, p. 106 u Question: Is real income a well defined concept? u Neutrality of money –a definition –is neutrality easy to prove or disprove? –does it hold?

Lecture Notes Finance 3197 Empirical Evidence u What are we trying to measure {and why}? –Production costs: home and abroad –Exchange rate risks »we face them no matter what »have to hedge!

Lecture Notes Finance 3198 Next Lecture: Interest Rate Parity u Interest Rate Parity = IRP u To read: Levich, Ch. 4 & 5 u Rogoff, Kenneth, (1996), “The Purchasing Power Parity Puzzle,” Journal of Economic Literature, Vol. 34, No. 2., pp (S)