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Eun8e CH 006 PPT
Eun8e CH 006 PPT
Exchange Rates
Chapter Six
Copyright © 2018 by the McGraw-Hill Companies,
Inc. All rights reserved.
Chapter Outline
• Interest Rate Parity
– Covered Interest Arbitrage
– IRP and Exchange Rate Determination
– Currency Carry Trade
– Reasons for Deviations from IRP
• Purchasing Power Parity
– PPP Deviations and the Real Exchange Rate
– Evidence on Purchasing Power Parity
• The Fisher Effects
• Forecasting Exchange Rates
– Efficient Market Approach
– Fundamental Approach
– Technical Approach
– Performance of the Forecasters
Copyright © 2014 by the McGraw-Hill Companies,
6-2
Inc. All rights reserved.
Interest Rate Parity Defined
• A theory in which the interest rate differential between
two countries is equal to the differential between the
forward exchange rate and the spot exchange rate.
• IRP is a “no arbitrage” condition. Interest rate and
exchange rates are in equilibrium.
• If IRP did not hold, then it would be possible for an astute
trader to make unlimited amounts of money exploiting
the arbitrage opportunity. (IR and ER not in equilibrium)
• Since we don’t typically observe persistent arbitrage
conditions, we can safely assume that IRP holds.
F$/£
Future value = $100,000(1 + i£)×
S$/£
If these investments have the same risk, they must have the
same future value (otherwise an arbitrage would exist).
F$/£ (1 + i$)
(1 + i£) × = (1 + i$) or; F$/£ = S$/£ × (1 + i )
S$/£ £
Alternative 2: $1,000 IRP
Send your $ on
S$/£ Step 2:
a round trip to
Britain Invest those
pounds at i£
$1,000 Future Value =
$1,000
(1+ i£)
S$/£
Step 3: Repatriate
Alternative 1: future value to the
Invest $1,000 at i$ U.S.A.
$1,000×(1 + i$) = $1,000
(1+ i£) × F$/£
S$/£
IRP
Since both of these investments have the same risk, they must have the
same future value—otherwise an arbitrage would exist.
Interest Rate Parity Defined
• If the amount is $1000;
$1,000
$1,000×(1 + i$) = (1+ i£) × F$/£
S$/£
F$/£
(1 + i$) = × (1+ i£)
S$/£
• IRP is sometimes approximated as:
i$ – i£ ≈ F – S
S
IRP and Covered Interest Arbitrage
F360($/£) = $2.01/£
• Why?
• If F360($/£) $2.01/£, an astute trader
could make money with one of the
following strategies.
Arbitrage Strategy I
• If F360($/£) > $2.01/£:
1. Borrow $1,000 at t = 0 at i$ = 3%. (Why borrow
$? Because it is undervalued at >$2.01/£)
2. Exchange $1,000 for £500 at the prevailing spot
rate (note that £500 = $1,000 ÷ $2/£.); invest £500
at 2.49% (i£) for one year to achieve £512.45.
3. Translate £512.45 back into dollars; if F360($/£)
> $2.01/£, then £512.45 will be more than enough
to repay your debt of $1,030.
Step 2: Arbitrage I
Buy pounds
£500 Step 3:
£1
£500 = $1,000× Invest £500 at
$2.00
i£ = 2.49%.
$1,000 £512.45 In one year £500
will be worth
£512.45 =
Step 4: Repatriate £500 (1+ i£)
to the U.S.
Step 1:
Borrow $1,000. More F£(360)
Step 5: Repay than $1,030 $1,030 < £512.45 ×
£1
your dollar loan
with $1,030.
If F£(360) > $2.01/£, £512.45 will be more than enough to repay your
dollar obligation of $1,030. The excess is your profit.
Arbitrage Strategy II
• If F360($/£) < $2.01/£ (dollar overvalue, or pound
undervalue):
1. Borrow £500 at t = 0 at i£= 2.49%.
2. Exchange £500 for $1,000 at the prevailing spot
rate; invest $1,000 at 3% for one year to achieve
$1,030.
3. Translate $1,030 back into pounds; if F360($/£) <
$2.01/£, then $1,030 will be more than enough to
repay your debt of £512.45.
Step 2: Arbitrage II
Buy dollars £500
$2.00
$1,000 = £500× Step 1:
£1
Borrow £500.
$1,000
More Step 5: Repay
Step 3: your pound loan
Invest $1,000 than
£512.45 with £512.45.
at i$ = 3%.
Step 4:
Repatriate to
the U.K.
In one year $1,000
F£(360)
will be worth $1,030 $1,030 > £512.45 ×
£1
If F£(360) < $2.01/£, $1,030 will be more than enough to repay your
dollar obligation of £512.45. Keep the rest as profit.
Reasons for Deviations from IRP
• Transactions Costs
– The interest rate available to an arbitrageur for
borrowing, ib, may exceed the rate he can lend at, il.
– There may be bid-ask spreads to overcome, Fb/Sa <
F/S.
– Thus, (Fb/Sa)(1 + i¥l) (1 + i¥ b) 0.
• Capital Controls
– Governments sometimes restrict import and
export of money through taxes or outright
bans.
F($/€) – S($/€) – €
= 1 + € ≈ $ – €
$
E(e) =
S($/€) (Relative PPP)
F($/€) – S($/€) i$ – i€
E(e) = = ≈ i$ – i€
S($/€) 1 + i€
Given the difficulty in measuring expected inflation,
managers often use a “quick and dirty” shortcut:
$ – € ≈ i$ – i€
E(e)
≈ IFE ≈ FEP
≈ PPP F–S
(i$ – i¥) ≈ IRP
S
≈ FE ≈ FRPPP
E($ – £)
E (S ¥ / $ )
IFE S¥ /$ FEP
1 + i¥ PPP F¥ / $
IRP
1 + i$ S¥ /$
FE FRPPP
E(1 + ¥)
E(1 + $)
Copyright © 2014 by the McGraw-Hill Companies,
6-28
Inc. All rights reserved.
Forecasting Exchange Rates: Efficient
Markets Approach
• Financial markets are efficient if prices reflect all
available and relevant information.
• If this is true, exchange rates will only change
when new information arrives, thus:
St = E[St+1]
and
Ft = E[St+1| It]
• Predicting exchange rates using the efficient
markets approach is affordable and is hard to
beat.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved. 6-29
Forecasting Exchange Rates: Fundamental
Approach
• Involves econometrics to develop models that
use a variety of explanatory variables. This
involves three steps:
– Step 1: Estimate the structural model.
– Step 2: Estimate future parameter values.
– Step 3: Use the model to develop forecasts.
• The downside is that fundamental models do not
work any better than the forward rate model or
the random walk model.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved. 6-30
Forecasting Exchange Rates: Technical
Approach
• Technical analysis looks for patterns in the past
behavior of exchange rates.
• It is based upon the premise that history repeats
itself.
• Thus, it is at odds with the EMH.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved. 6-31
EXHIBIT 6.11 Moving Average Crossover
Rule: Golden Cross vs. Death Cross
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Performance of the Forecasters
• Forecasting is difficult, especially with regard to
the future.
• As a whole, forecasters cannot do a better job of
forecasting future exchange rates than the
forecast implied by the forward rate.
• The founder of Forbes Magazine once said,
“You can make more money selling financial
advice than following it.”
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved. 6-33
Summary
• Interest rate parity (IRP) holds that the forward premium
or discount should be equal to the interest rate
differential between two countries.
– IRP represents an arbitrage equilibrium condition that should
hold in the absence of barriers to international capital flows.
• If IRP is violated, one can lock in guaranteed profit by
borrowing in one currency and lending in another, with
exchange risk hedged via forward contract.
– As a result of this covered interest arbitrage, IRP will be restored.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved. 6-34
Summary (continued)
• IRP implies that in the short run, the exchange rate
depends on
– (a) the relative interest rates between two countries, and
– (b) the expected future exchange rate
– Other things being equal, a higher (lower) domestic interest rate
will lead to appreciation (depreciation) of the domestic currency.
People’s expectations concerning future exchange rates are self-
fulfilling.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved. 6-35
Summary (concluded)
• Purchasing power parity (PPP) states that the exchange
rate between two countries’ currencies should be equal
to the ratio of their price levels.
– The relative version of PPP states that the rate of change in the
exchange rate should be equal to the inflation rate differential
between countries. The existing empirical evidence, however, is
generally negative on PPP. This implies that substantial barriers
to international commodity arbitrage exist.
• There are three distinct approaches to exchange rate
forecasting:
– (a) the efficient market approach,
– (b) the fundamental approach, and
– (c) the technical approach.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved. 6-36