Topic 2: Overview of the foreign exchange market and exchange rate determination

1
Topic 2 Overview of the foreign exchange market
and exchange rate determination

2
What 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.

3
The Magnitude of the Global Foreign Exchange
Market
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The 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)

5
Currency Distribution of GlobalTraditional
Foreign Exchange Market Activity
Other Currencies
Australian Dollar
Canadian Dollar
US Dollar
Swiss franc
Pound Sterling
Japanese Yen
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The Market that Never Sleeps
7
The 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.

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What 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

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Supply 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
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Supply 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
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Supply 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
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So, 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..
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Trade 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

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Investment 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?

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Investment 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

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Interest 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
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Example 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

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Example 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
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Asset 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?

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Asset 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

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Brazilian Real to USD daily change
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Asset 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

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This 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?

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What 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

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The law of one price

• A identical good should cost the same in all
  markets

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The 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

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Purchasing 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.
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Purchasing 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.
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Relative 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
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Who 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)

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Purchasing 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!

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Does 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
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Burgernomics 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.

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Burgernomics 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

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The saying goes

• Italians like their coffee strong and their
  currency weak
• Lets see if they have legitimate grip about the
  strength of the Euro

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3.06 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
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Overall, 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
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For a short video on the Big Mac index

• http//www.economist.com/media/audio/burgernomics.
  ram

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Thats 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)
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Burgers 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.

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Even 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.

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Another 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

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The Big Mac Index of Cigarette Affordability
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Burgernomics (cont.)

• While originally introduced as a bit of fun, it
  has inspired several serious studies

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Burgernomics (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

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Burgernomics (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

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Parsley 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.

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Burgernomics (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.

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Other 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?

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Testing 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?

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Testing 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?

52
Testing 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.

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Testing 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
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Empirical 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)
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Quarterly Deviations from Relative PPPCPI
Germany and the United States, 1973-1999
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Quarterly 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

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Long 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.

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Long 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

59
Long 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.

60
Empirical 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.

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Implications

• 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?

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The 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
63
Interest 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.
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Who 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.
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Interest 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

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Interest Rate Parityin a Perfect Capital Market

• Driven by covered interest arbitrage, the two
  investments should produce identical ending
  wealth. So,

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IRP 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.

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IRP 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
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IRP 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
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IRP 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?
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Covered 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
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Interest 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.

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The Interest Rate Parity LineEquilibrium and
Disequilibrium Points
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Relaxing 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?

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Relaxing thePerfect Capital Market Assumptions

• Transaction costs has the effect of creating a
  neutral band within which covered interest
  arbitrage transactions will not occur.

76
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.

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Eurocurrency 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)

78
Growth 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

79
Growth 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

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Growth 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

81
Growth 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.

82
Pricing of Eurocurrency Deposits and Loans
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84
Can 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.

85
Back 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.

86
Empirical 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?

87
Empirical 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

88
Empirical 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.

89
The 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
90
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91
The 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
92
The 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

93
How 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)

94
The 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.

95
Empirical 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

96
The 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).
97
The 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.
98
The 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?

99
Foreign Rate as Unbiased Predictor of Future Spot
Rate
100
The 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

101
OK, 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.

102
OK, 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,..

103
Your 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.

104
Parity 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

105
Next Topic Market Efficiency

• Can we make in the FX market?