Title: Topic 2: Overview of the foreign exchange market and exchange rate determination
1Topic 2 Overview of the foreign exchange market
and exchange rate determination
2What will we do
- Examine the Size of the FX market
- Discuss factors that may cause exchange rates to
change - Introduce Parity Conditions and discuss their
empirical validity (The classics) - This allows us to insights both on the causes
exchange rates changes, and it will help us
understand the next topics of market efficiency
and forecasting in the FX market.
3The Magnitude of the Global Foreign Exchange
Market
4The Magnitude of the Global Foreign Exchange
Market
- Fact Foreign Exchange trading volume is HUGE
- In 2004, we see daily spot and forward/swap
market volume is about 1.9 trillion or nearly 470
trillion per year. - To compare, the highest daily volume in NYSE
history was September 17th, 2001 2.37 billion
shares - The annual volume of FX trading is 53 times
larger than annual world trade (2004 Word trade
was 8.8 Trillion) - The annual volume of FX trading is over 10 times
larger than world GDP (41 Trillion)
5Currency Distribution of GlobalTraditional
Foreign Exchange Market Activity
Other Currencies
Australian Dollar
Canadian Dollar
US Dollar
Swiss franc
Pound Sterling
Japanese Yen
6The Market that Never Sleeps
7The Market that Never Sleeps
- The forex market is a true 24-hour market that's
traded 5.5 days a week - The forex market literally follows the sun around
the world, moving from major banking and
financial centers of the United States to
Australia and New Zealand to the Far East, to
Europe and finally back to the United States. - During each trading day, overall forex volume is
determined by what markets are open and the times
each of these markets overlap one another. With
each passing second, minute and hour, forex
volume remains high, but peaks highest when the
British, European and U.S. markets are open at
the same time - from 1 p.m. GMT to 4 p.m. GMT.
8What determines FX rates? Supply and Demand?
- Fact Exchange Rates are Asset Prices-Does this
make sense? - The asset is foreign exchange i.e. foreign
money - Its price is the exchange rate the amount of
domestic money we pay to get one unit of foreign
money - That means we can analyze exchange rates the same
way we analyze other asset prices Supply and
Demand
9Supply and Demand (cont.)
- Trade Influences How do you think international
trade affects the supply and demand for
currencies? - Businesses will often require they are paid in
their domestic currency (why?). - This means that international trade generates
demands for foreign currency - The more Porsches we import from Germany, the
__________ Euro we need - Since we swapping currencies , this also
____________ the supply of USD to foreigners (or
whoever supplies the Euro)
more
increases
10Supply and Demand (cont.)
- Example Productivity
- Suppose US productivity improves
- US goods are now _________ to make
- Because of the price, foreign demand for our
goods __________. - This _________ demand for USD, so dollar
___________. -
cheaper
increases
increases
appreciates
11Supply and Demand (cont.)
- Another Example Printing Money
- Suppose the Russian government decides to print
more money to help pay its budget deficits - Since there are now more rubles chasing the same
amount of goods, prices of Russian goods in RUR
will ______. - At higher prices in RUR, demand for Russian
exports will _____. - Demand for RUR falls, so the ruble_______________
rise
fall
depreciates
12So, Does Trade Determine Exchange Rates?
- The previous examples suggest that trade factors
will have a big impact on the supply and demand
for foreign exchange - While trade factors do have an influence, they
are not the whole story
So the class continues..
13Trade as a Determinant of Exchange Rates
- Recall The volume of foreign exchange traded in
a single day is typically enough to finance many
sectors of international trade for a year! - So what have we missed?
- The fact that Investors play a major role in the
supply and demand of currencies
14Investment Supply and Demand of Foreign Exchange
- When investing in a country, what happens to the
demand for the countries currency? Why? - Conversely, what happens when investors flee a
country? - Think about capital controls
- How might these impact the exchange rate?
-
15Investment Supply and Demand of Foreign Exchange
- Obviously, investors care about the return on
their investment - What are the components?
- interest and capital gains/losses
- In the case of international investment, they
care about the relative return on their
investment - What additional factors do we have to worry
about? - Appreciation or depreciation of the currency
16Interest Rates and Exchange Rates
- When a particular country has relatively high
interest rates, what do you think it tends to do
the currency? Why? - Higher interest rates tend to the
value of a currency - Higher real interest rates, that is.
- How does this work?
- Increases the demand for the currency, therefore
its price
raise
17Example Canada US interest rate linkages
- Suppose that over the past months, the Fed has
lowered the Fed. Funds rate several times How
does it affect US interest rates? - This is generally taken as a signal of looser
monetary policy and lowers interest rates in the
US - Bank of Canada officials have to decide how to
respond
18Example Canada US interest rate linkages
- Bank of Canada officials have to decide how to
respond - What if they do nothing?
- CAD may __________ because of relatively high
Canadian interest rates - What could this do to demand for Canadian
products? - May cause Canadian exports to be come expensive
and hurt trade and the economy
appreciate
19Asset Markets and Expectations
- Broadly speaking, what do you think are some
factors that currency investors care about? - risk, capital gains, appreciation, depreciation
- The factors that investors care about are
subjective and forward looking - Another way, they depend in some measure on what
investors expect the future will bring - Does this remind you of any other market?
20Asset Markets and Expectations
- Expectations can change fast
- Real economies dont change by 10 in a few hours
- Exchange rates sometimes do
- FACT Exchange rates appear to be much more
volatile than real economic factors
21Brazilian Real to USD daily change
22Asset Markets and Expectations
- Exchange rates can react on the news of the event
more than the event - Can you think of any examples?
- Remember the impact of Yeltsins health on the
Ruble
23This all seems rather ad hoc, how do we figure
what causes exchange rate changes?
- We go back to international Parity Conditions
- The parity conditions give us a starting point to
answer some important questions - Are changes in exchange rates predictable?
- How are exchange rates related to interest rates?
- What, at least theoretically, is the proper
exchange rate?
24What is, at least theoretically, the proper
exchange rate?
- This is given by our first parity relationship
- PURCHASING POWER PARITY (PPP)
- Provides a benchmark to suggest the levels that
exchange rates should achieve. - Starts with the Law of One Price
25The law of one price
- A identical good should cost the same in all
markets -
26The Law of One Price
- Applied internationally, a good should cost the
same in all countries when measured in the same
currency -
-
- Which implies an exchange rate of
-
27Purchasing Power Parity Absolute Version
The price of a market basket of U.S. goods equals
the price of a market basket of foreign goods
when multiplied by the exchange rate.
Driven by arbitrage in goods.
28Purchasing Power Parity Relative Version
The percentage change in the exchange rate equals
the percentage change in U.S. goods prices less
the percentage change in foreign goods prices.
Also Driven by arbitrage in goods.
29Relative Purchasing Power Parity
Stated another way
Rate of change in S Domestic inflation
Foreign Inflation
- Key insight Relative PPP focus on changes in the
exchange rate, not levels - Key Prediction Relative PPP says domestic and
foreign inflation determine the dynamics of the
spot exchange rate.
e ?U.S. - ?For
30Who came up with PPP and why?
- Our First Famous Dead Guy Gustav Cassel
- He popularized PPP in the 1920s to explain
- what was going on in the world at that time
- In those years, many countries (Germany,
- Hungary, and the Soviet Union) had experienced
- Hyperinflation.
- As the purchasing power of these countries
sharply declined, the same currencies also
depreciated sharply against stable currencies
like the U.S. dollar - PPP became popular then, how about now (think
Latin America)
31Purchasing Power Parity Caveats
-
- PPP conditions do not imply anything about causal
linkages between prices and exchange rates or
vice versa. - Both prices and exchange rates are jointly
determined by other variables in the economy. - PPP is an equilibrium condition that must be
satisfied when the economy is at its long-term
equilibrium. - It does, however, give us a powerful tool if it
holds!
32Does PPP hold?
- Lets test absolute PPP first.
- How would devise a test of absolute PPP?
- The most famous test of absolute PPP is The
Economist magazine's
Big Mac Index
33Burgernomics The Big Mac Index
- The Economists Big Mac index was first launched
in 1986 as a gastronomes guide to whether
currencies were at their correct exchange rate. - Examines the price of a common good (the Big Mac)
worldwide.
34Burgernomics The Big Mac Index
- Before we get serious, some little known Big Mac
Triva - By 1996, you could get one in 80 countries
- In China, it is know as Juwuba, big with no
equal - In Moscow and Beijing, the McDonalds has over 700
seats and 30 registers
35The saying goes
- Italians like their coffee strong and their
currency weak - Lets see if they have legitimate grip about the
strength of the Euro
363.06 Average of NY, Chicago, SF
2.92 Euros Price of Big Mac in Euro member
countries, which at current FX rate of 1.22 is
3.58
S3.06/2.921.05
However, actual exchange rate is 1.22, so Euro is
overvalued 17
37Overall, we can get a Big Mac for really cheap in
countries like China, Malaysia, Thailand,
Philippines However, it costs 5.05 USD for one
in Switzerland So, it implies that Switzerland
has the most overvalued currency and the others
the most undervalued
38For a short video on the Big Mac index
- http//www.economist.com/media/audio/burgernomics.
ram
39Thats just one good Can you think of another
item that is available just about anywhere?
The Tall-Latte Index
Available in 32 countries. Average price in US
(2004) was 2.80 (about the same as a big mac)
40Burgers or Beans?
- Do we see the same story?
- The tall-latte index tells broadly the same story
as the Big Mac index for most main currencies - Where the two measures differ is in Asia In
China, it is 56 undervalued according to the Big
Mac, but spot on its dollar PPP according to our
Starbucks index. If so, American manufacturers
have no grounds to complain about the yuan. The
pricing differences probably reflect different
competition in the markets for the two products.
41Even more fun with Burgernomics
- Working time needed to buy a Big Mac
- It aims to measure well-being by estimating how
many minutes workers in various countries must
toil to buy a Big Mac. - In Kenya, UBS says that it takes just over three
hours of labor for a typical worker to afford one
of McDonald's hefty burgers. - Americans, lucky for them, need to work for only
ten minutes. Such differences reflect variations
in productivity as well as disparities in local
costs of ingredients.
42Another application The Big Mac Index of
Cigarette Affordability
- In calling for increases in tobacco tax, tobacco
control advocates often find it useful to compare
cigarette prices internationally with those in
their own country. - To do this, they must somehow convert prices in
other countries using a standard measure, most
commonly the price in US. Exchange rates,
however, may be influenced by many factors
including inflation differentials, monetary
policy, balance of payments, and market
expectations - The Big Mac index of cigarette affordability
provides a reasonable estimation of relative
affordability of cigarettes
43The Big Mac Index of Cigarette Affordability
44Burgernomics (cont.)
- While originally introduced as a bit of fun, it
has inspired several serious studies -
45Burgernomics (cont.)
- Pakko and Pollard (1996) conclude that
- Big Mac PPP holds in the long run, but
currencies can deviate from it for lengthy
period. They note several reasons why the Big Mac
index may be flawed - The absolute version of PPP assumes there are no
barriers to trade. - High prices in Europe, Japan and South Korea
partly reflect high tariffs on beef. Differences
in transport costs also matter shipping lettuce
and beef is expensive
46Burgernomics (cont.)
- 2. Prices are distorted by taxes
- High rates of VAT in countries such as Denmark
and Sweden exaggerate the degree to which their
currencies are overvalued - 3. Profit margins vary amount countries according
to competition - In the US, we have the Whopper, other countries
do not have a close substitute
47Parsley and Wei (2004)
- Estimate that non-traded inputs, such as labour,
rent and electricity, account for between 55 and
64 of the price of a Big Mac. - The two economists disassemble the Big Mac into
its separate ingredients. They find that the
parts of the burger that are traded
internationally converge towards purchasing-power
parity quite quickly. Any disparity in onion
prices will be halved in less than nine months,
for example. But the non-traded bits converge
much more slowly a wage gap between countries
has a half-life of almost 29 months. - Seen in this light, the Big Mac index provides
little comfort to Italian critics of the single
currency. If the euro buys less burger than it
should, perhaps inflexible wages, not a strong
currency, are to blame.
48Burgernomics (cont.)
- So what do we make of the Big Mac index?
- Despite its weaknesses, which The Economist has
long acknowledged, the Big Mac index often comes
up with PPP estimates similar to more
sophisticated methods.
49Other evidence on absolute PPP
- With the rise of e-commerce, investigating the
Law of One Price becomes easier and violations
more puzzling. - A recent Wall Street Journal article highlighted
the case of a popular book that sold for 16.20
at Amazon.com (U.S.), for 13.52 at Amazon.co.uk
(Britain), and for 27.00 at Amazon.de (Germany). - Clearly, absolute PPP seems not to hold
- See Titleist ProV1, Cheap Canadian Drugs, etc.
etc., - Can we do better?
50Testing PPP
- How would devise a serious test of absolute PPP?
(think about hamburger example) - Big Mac, Whopper, Wendys Triple etc, and thats
just burgers! What about every other good in the
economy? - All you have is price indices (consumer price,
producer price, etc.) - Although an index covers all goods in the
economy, it is arbitrarily set to 100 or 1 at
some point in time. - So, what does this say about our ability to get
the absolute price level?
51Testing PPP Price Indices
- If the absolute price level cant be derived,
what do we conclude about our ability to test
absolute PPP? - Absolute PPP cant be tested (unless you are
willing to use Big Macs) - However, a change in the price index corresponds
to the exact same relative change in the absolute
price - What does this say about our ability to test
relative PPP? Why?
52Testing Relative PPP
- A parity condition can be viewed as a 45 line
passing through the origin with the LHS and RHS
variables plotted on the x and y axes. - Thus, parity conditions can be tested by running
the simple linear regression - LHSt ? ? RHSt ?t
- Parity holds when the data cannot reject a null
hypothesis where ? 0, ? 1, and the error
terms have classical properties.
53Testing PPP
Currencies with the largest relative decline
(gain) in purchasing power saw the sharpest
erosion (appreciation) in their foreign exchange
rate
As measured by relative inflation rates
54Empirical Evidence onPrices and Exchange Rates
- To examine the relative PPP condition, we can
compare the exchange rate change to the
contemporaneous inflation differential -
- st ? ? (p pDM)t ?t
Lets look the short-run data (Quarterly)
55Quarterly Deviations from Relative PPPCPI
Germany and the United States, 1973-1999
56Quarterly Deviations from Relative PPPCPI
Germany and the United States, 1973-1999
- It seems that PPP is a poor explanation of
exchange-rate changes on a period-by-period
basis. - However, there is a tendency for PPP to reassert
itself in the long run (mean reversion). - Lets have a look at your homework problem
57Long Run PPP Tests
- Data on price indexes and exchanges in 1973 and
1993 for 22 OECD countries are provided. Estimate
a regression of the form Yi a bXi - where Y is the exchange rate change over the
20-year period and X is the inflation difference
(foreign to US) over the 20-year period for
i1,..,22 countries. -
58Long Run PPP Tests
- A tip Use Natural Logs to do this. Recall that
the change from 1993 to 1973 can be expressed as
the Ln(S1993 / S1973 ). The inflation difference
is - LN(CPI1993 / CPI1973 ) - LN(CPI1993 / CPI1973
) - Foreign US
-
59Long Run PPP Tests
- What do your results say about the relation
between inflation and exchange rates over the
long term? - Make sure to comment on the each coefficient
(a,b), its statistical significance, its
economic meaning, and the fit of the regression.
60Empirical Evidence onPrices and Exchange Rates
- Empirical tests confirm that ...
- PPP is a poor descriptor of exchange rate
behavior in the short run, where the rates are
quite volatile and domestic prices are somewhat
sticky (e.g., restaurant menus). - But in longer-run analysis, it appears that PPP
offers a reasonably good guide. - Homework problem lets you see if you believe this.
61Implications
- If managers can identify the deviations from
parity that are growing larger or likely to
persist, then profit-maximizing decisions can be
made. - Knowing that deviations from parity occur,
managers may adopt strategies that reduce their
exposure to the risks of such deviations. - Example Suppose you see the exchange rate is
overvalued in the UK (according to PPP). What
would be your prognosis of the long term movement
of the exchange rate? How could that influence
your business decisions?
62The Final Word on PPP
Despite often lengthy departures from PPP, there
is a clear correspondence between relative
inflation rates and changes in nominal exchange
rates
1
- Next , we look at other parity relationships that
provide insights into what determines FX rates
2
63Interest Rate Parity The Relationship between
Interest Rates, Spot Rates, and Forward Rates
The forward exchange rate premium equals
(approximately) the U.S. interest rate minus the
foreign interest rate.
Driven by arbitrage between the spot and forward
exchange rates, and money market interest rates.
64Who came up with this?
Another Famous Dead Guy John Maynard Keynes
(1923) made an early formulation of IRP, but the
relationship seems to have been well know in
earlier times.
65Interest Rate Parityin a Perfect Capital Market
- IRP draws on the principle that in equilibrium,
two investments exposed to the same risks must
have the same returns. - Suppose an investor puts 1 in a US security. At
the end of one period, wealth 1 ? (1 i) - Alternatively, the investor can put the 1 in a
UK security and cover his or her exposure to UK
exchange rate changes. At the end of one period,
wealth
66Interest Rate Parityin a Perfect Capital Market
- Driven by covered interest arbitrage, the two
investments should produce identical ending
wealth. So,
67IRP and Covered Interest Arbitrage
- Lets review, The process of covered interest
arbitrage (CIA) occurs whenever IRP does not
hold. Why? - Borrow the domestic currency
- Exchange the domestic currency for the foreign
currency in the spot market - Invest the foreign currency in an
interest-bearing instrument and then - Sign a forward contract to lock in a future
exchange rate at which to convert the foreign
currency proceeds back to the domestic currency.
68IRP and Covered Interest Arbitrage
- Example A. Suppose you see the following quotes
- 3-month eurodollar rate5.96 p.a.
- 3-month europound rate8.00 p.a.
- St 1.5000/BP Ft,3month1.4925/BP
- Is IRP holding?
- Check it
-0.005 -0.005
69IRP and Covered Interest Arbitrage
- The term (FS)/S is called the forward premium.
- When (FS)/S lt 0, the term forward discount is
often used. - In this example, what is the forward premium?
Forward Discount
70IRP and Covered Interest Arbitrage
- What is the interest differential between the
dollar and pound?
Given that BPs are at a forward discount, does
it make sense that U.K. interest rates are higher
than US rates? Why?
71Covered Interest Arbitrage (CIA)
- Example A Now, suppose Ft,3month1.52/BP
rather than 1.4925/BP
1,014,900
1,033,600
Profit 18700
BP666666.7
BP680,000
72Interest Rate Parityin a Perfect Capital Market
- When the forward premium or discount is plotted
against the interest rate differential, the 45
line represents the interest rate parity line. - The IRP line represents the dividing line between
investments in the domestic security and
investments in the foreign security that have
been covered against exchange risk.
73The Interest Rate Parity LineEquilibrium and
Disequilibrium Points
74Relaxing thePerfect Capital Market Assumptions
- The graph shows it is profitable to conduct CIA
when the market is off the 450 line. - What do you think the effect of transactions
costs will be?
75Relaxing thePerfect Capital Market Assumptions
- Transaction costs has the effect of creating a
neutral band within which covered interest
arbitrage transactions will not occur.
76Empirical Evidence on Interest Rate Parity
If you want to test IRP, what data do you need?
- Spot exchange rates, interest rates, forward
rates
- Early tests used short-term government
securities. Does this seem right? - Not surprisingly, they found some deviations from
IRP - However, using the growth of the Eurocurrency
markets in the 1960s made it possible to examine
two securities that differed only in terms of
their currency of denomination.
77Eurocurrency markets
- Consists of bank loans and deposits outside the
jurisdiction of the currency of denomination - Dollar deposits outside the U.S.
- Called offshore market
- Where is this Market?
- Western Europe, in particular London
- The Caribbean (e.g. Cayman Islands)
- Middle East (e.g. Bahrain)
- Asia (e.g. Singapore)
78Growth of Eurocurrency markets
- Main reason To avoid domestic financial
restrictions - 1950 beginning of Cold War, Soviet Union decides
to invest dollars in London and Paris (telex
codeEUROBANK) - 1956 Sterling crisis, due to Suez canal affair,
forces the Bank of England to prohibit loans in
sterling to non-residents. In response, British
banks create a dollar market outside the US
79Growth of Eurocurrency markets
- 1963-1973 Large deficits in US balance of
payments causes Kennedy to impose the Interest
Equalization Tax (IET), that taxes U.S. purchases
of foreign securities in response, lenders and
borrowers extend the dollar market in London - 1968 Interests rates climb above the maximum
rates that US banks can offer (because of
regulation Q) in response, banks offer highest
rates in euromarkets
80Growth of Eurocurrency markets
- Euro deposits are not subject to domestic banking
regulations - Regulation M requires non interest bearing
reserves to be held with the central bank (about
12 in US) - Compulsory Federal Deposit Insurance (FDIC), with
an insurance premium of about 0.5 of deposits
81Growth of Eurocurrency markets
- The market has grown from essentially zero in
1960 to roughly 9.5 trillion on a gross basis
and 5.5 trillion on a net basis in 1999. - The U.S. dollar is the main currency, while
Europe is the dominant region for Eurocurrency
deposits.
82Pricing of Eurocurrency Deposits and Loans
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84Can Offshore and Onshore Markets Coexist?
- If the offshore market provides a similar service
at a lower cost, what prevents all onshore
transactions from migrating there? - Offshore depositors bear the additional risk of
exchange controls or taxes, plus the
inconvenience of having deposits outside their
home country. - For borrowers, size and credit quality may act as
barriers that restrict some firms from access to
the offshore market.
85Back to Empirical Evidence on Interest Rate
Parity
- If you want to test IRP, what data do you
need?
- Spot exchange rates, interest rates, forward
rates
- Early tests used short-term government
securities. Does this seem right? - Not surprisingly, they found some deviations from
IRP - However, using the growth of the Eurocurrency
markets in the 1960s made it possible to examine
two securities that differed only in terms of
their currency of denomination.
86Empirical Evidence on Interest Rate Parity
- Given that the IRP line is at 450 line passing
thru the origin, could we just test if ? 0 and
?1 in
- OLS will give us an average, does this seem
appropriate given what we want? - What about transactions costs?
87Empirical Evidence on Interest Rate Parity
- Testing IRP involves looking at each observation
and seeing if it was possible to profit after
transactions costs. - If the percentage of profitable trades is small,
we conclude IPR holds. - Intuition Think of market efficiency tests
-
88Empirical Evidence on Interest Rate Parity
- The general result is that IRP holds in the
short-term Eurocurrency market after accounting
for transaction costs. - But dont take some pointy headed academics
word, check it yourself (homework1) - For longer-term securities, a study found
significant deviations from parity that represent
profit opportunities even after adjusting for
transaction costs. - The authors argue that deviations from parity
represent a window of opportunity for firms and
this may partly explain the rapid growth in
long-term currency swaps.
89The Fisher Parities
- Famous dead guy Irving Fisher (1867-1947)
This Yale economist was an eccentric and colorful
figure. When Irving Fisher wrote his 1892
dissertation, he constructed a remarkable machine
equipped with pumps, wheels, levers and pipes in
order to illustrate his price theory. Socially,
he was an avid advocate of eugenics and health
food diets.  He made a fortune with his visible
index card system - known today as the rolodex -
and advocated the establishment of an 100
reserve requirement banking system  His fortune
was lost and his reputation was severely marred
by the 1929 Wall Street Crash, when just days
before the crash, he was reassuring investors
that stock prices were not overinflated but,
rather, had achieved a new, permanent plateau
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91The Fisher Parities
- Recall his domestic equation
-
- Since E(?) x E(r) is often small,
nominal rate ? real rate expected
inflation
- This is the some one you use in all your other
finance classes, called
The Fisher Closed
92The International Fisher Effect
- The International Fisher Effect, also Fisher
Open, says the spot exchange rate should change
in an equal amount but in opposite direction to
the difference in interest rates between
countries
93How to think of this Intuition
- Investors must be rewarded or penalized to
offset the expected change in exchange rates. - Predicts that investors should be indifferent
between investments across countries, or would
buy low and sell high and arbitrage away the
difference. (not riskless, uncovered)
94The International Fisher Effect
- The markets implied future spot rate
- So, the market expects the US to
__________when US interest rates are lower than
foreign interest rates, and vice versa. -
appreciate
- Note that the International Fisher Effect
implicitly assumes that real interest rates are
equal across countries.
95Empirical Evidence onthe International Fisher
Effect
- Empirical tests indicate that the International
Fisher Effect condition performs poorly in
individual periods. - However, over extended periods of time, it
appears that currencies with high interest rates
tend to depreciate, and vice versa, as predicted. - The most serious criticism of IFE is new evidence
of an exchange risk premium in most major
currencies, so expected changes in exchange rates
may not always be equate real interest rates
96The Forward Rate Unbiased Condition
Forward Rate Unbiased
Todays forward premium (for delivery in n
days) equals the expected percentage change in
the spot rate (over the next n days).
Driving force Market players monitor the
difference between todays forward rate (for
delivery in n days) and their expectation of the
future spot rate (n days from today).
97The Forward Rate Unbiased Condition
- From IRP and the International Fisher Effect
If the average deviation between todays Ft,1 and
the actual future St 1 is small and near zero,
then the forward rate is an unbiased predictor
of the future spot rate.
98The Forward Rate Unbiased Condition
What does unbiased mean?
If UIP holds
- Then forward rates are correct on average
- Does this mean we will not have FX losses?
- What does this imply about market efficiency?
99Foreign Rate as Unbiased Predictor of Future Spot
Rate
100The Forward Rate Unbiased Condition
If UIP does not holds
- Positions in different currencies can lead to
profit opportunities - Could imply market inefficiency
Empirical Evidence
- Early studies were supportive
- Recent studies are not
- People are willing to pay for FX advisors
- More when we get to Market Efficiency
101OK, ENOUGH ALREADY What are the takeaways from
the Parity Conditions?
- When IRP holds, the covered cost of funds is
identical across all currencies and the covered
return on funds is identical across all
currencies there are neither bargains or nor bad
deals on a covered basis. - When the International Fisher Effect Holds, the
expected cost of borrowed funds is identical
across currencies and the expected return on
invested funds is identical across currencies on
an uncovered basis. - Some currencies may have high nominal interest
rates and others may have low nominal interest
rates, but when the expected exchange rate change
is taken into account, all currencies return the
same nominal interest rate.
102OK, ENOUGH ALREADY What are the takeaways from
the Parity Conditions?
- When the forward rate unbiased condition holds,
the expected cash flows associated with hedging
or not hedging a currency exposure are identical.
- Another words, when the forward rate equals the
expected future spot rate, those who hedge and
those who do not hedge have the same expected
domestic currency results. - If all the parity conditions were valid at each
and every point in time, then all financial
choices would be fairly price (zero NPV
projects). However,..
103Your Tests of Parity Conditions Reveal that
Deviations Sometimes Exist
- Therefore, managers may have an opportunity to
make profit maximizing decisions by exploiting
deviations from the parity conditions. - Alternatively, if managers assess a risk of large
deviations from parity conditions, then
strategies to avoid or hedge these risks may be
called for.
104Parity relationshipsSumming Up
- Remember, we are still trying to answer
- Are Changes in exchange rates predictable?
- How are exchange rates related to interest rates?
- What is, at least theoretically, the proper
exchange rate? - These have have obvious implications for
- Managers of multinational firms
- International investors
- Importers and Exporters
- Government officials
105Next Topic Market Efficiency
- Can we make in the FX market?