Contents of the course

1
International Finance
Part 1 Fundamentals of International Finance
Lecture n2 Purchasing Power Parity Interest
Rate Parity
2
Part 1 - Contents

• Part 1 Fundamentals of International Finance
  (10 hrs)
• Echange rate determination
• Purchasing power parity and interest parity
  relations
• Exchange rate determination
• Exchange rate management and targets
• Monetary integration in the European Union
• The IMF and the provision of finance

3
Purchasing Power Parity

• Two basic concepts of exchange rate determination
• Purchasing Power Parity (PPP)
• Interest Rate Parity
• Absolute Purchasing Power Parity - Definition
• P S.P law of one price
• Domestic Prices Exchange Rate . Foreign prices
• P and P general price indices
• Rearranging S P/P
• The spot exchange rate between 2 currencies is
  equal to the ratio of general price levels
  between the 2 countries.

4
Purchasing Power Parity

• Absolute Purchasing Power Parity - Definition
• R S.P/P real exchange rate
• R measure of a countrys competitiveness
• R is constant over time under the PPP model.
• Relative Purchasing Power Parity - Definition
• S b.P/P
• Prices across countries might differ by a
  constant factor b, accounting for transport
  costs and information costs.
• Focuses on the movements in the exchange rate and
  the extent to which they reflect differential
  inflation
• dS/S dP/P - dP/P

5
Purchasing Power Parity

• Absolute Purchasing Power Parity - Hypotheses
• Hypotheses
• No transports costs
• Perfect information (on prices in both countries)
• Homogeneous goods
• No trade barriers
• -gt Equality brought by arbitrage

6
Purchasing Power Parity

• PPP absolute relative - Interpretation ?
• No precision of causality does the prices
  determine the X rate, or the reverse?
• Goods included traded non traded? If yes,
  hypothesis of perfect substitutability and
  similar productivity levels.
• If only traded goods included PPP close to a
  tautology
• Short-run or long-run anchor?
• -gt alternative cost parity theory
• (more seducing, but same nature of problems)

7
Purchasing Power Parity

• PPP absolute relative - Theoretical criticisms
  (6)
• Information costs, transport costs, trade
  barriers exist, and could change over time.
• The direction of causality is unclear -gt exchange
  rates could determine prices.
• All disturbances are monetary, or more important
  than real ones -gtno account of productivity
  changes in one country.
• No account of productivity differential between
  traded non-traded goods sectors.
• Ignores the role of income in determining
  exchange rates, and its consequences on a change
  in Demand.
• No role of capital flows. Only focus on exchange
  of goods.

8
Purchasing Power Parity

• PPP absolute relative - Empirical testing
• Tests of commodity arbitrage, of the absolute
  version and on the relative version.
• Methods used
• Regressions
• Plots of data
• Cointegration tests (for the long-term
  relationship)
• -gt Commodity arbitrage appear not to maintain the
  law of one price. Little empirical support.
• Recent multivariate cointegration tests some
  support (relative version) for some large
  currencies.

9
Interest Rate Parity

• Two basic concepts of exchange rate determination
• Purchasing Power Parity (PPP)
• Interest Rate Parity
• Interest Rate Parity - Definition
• Covered interest rate parity (CIP)
• Uncovered interest rate parity (UIP)
• Real interest rate parity
• Unlike the PPP, CIP / UIP theories explicitly
  involves the role of capital flows.

10
Interest Rate Parity

• Covered Interest Rate Parity - Definition
• CIP states that returns between assets in
  different countries should be equalised.
• If they are not, equalisation is brought by
  arbitrage.
• It gives
• (1it) . Ft/St (1it)
• Return of foreign invt return of domestic invt
• where
• it foreign interest rate it domestic
  interest rate
• Ft forward exchange rate
• St spot exchange rate

11
Interest Rate Parity

• Covered Interest Rate Parity - Hypotheses
• Assets same risk, same maturity
• No transaction costs
• No information costs
• No control on capital flows
• Plus, the transaction of in the forward market
  implies that there is no foreign exchange risk
  (risk that S changes while investing abroad).
• Arbitrage Ex. return greater abroad, we have
• (1it) . Ft/St gt (1it)
• -gt Investors will buy spot rate and sell forward
  (to invest abroad), causing S to rise and F to
  fall, getting back to equality.

12
Interest Rate Parity

• Covered Interest Rate Parity - Empirical tests
• Methods
• Plot the different interest rates separately and
  compare
• Test if deviations are significantly different
  from zero
• Regressing the forward premium on (i-i) by
• fp a b(i-i) if b1, a 0, CIP holds (i-
  fpi)
• Deviations not uncommon, supposedly due to
• transaction costs (to what extent?)
• the existence of capital controls (Gibson (1989)
  CIP holds when controls on capital are removed)
• the existence of political risks risks of
  capital controls or taxes before funds are
  repatriated.

13
Interest Rate Parity

• Uncovered Interest Rate Parity - Definition
• UIP CIP foreign exchange risk
• States that returns between assets in different
  countries should be equalised, plus a deviation
  accounting for exchange risk. It gives
• i ? Se i
• where
• i foreign interest rate i domestic
  interest rate
• ? Se expected change in the spot exchange rate
• This relation holds if the path of the exchange
  rate is known with certainty, or if arbitrageurs
  are risk neutral.

14
Interest Rate Parity

• i ? Se i
• States that if the foreign interest rate is
  higher than the domestic rate, then the domestic
  currency must be expected to appreciate, to
  maintain this relationship (otherwise
  arbitrage).
• Uncovered Interest Rate Parity - Hypotheses
• Rational expectations, i.e., forward market is
  efficient
• Risk neutrality of arbitrageurs
• If risk aversion of arbitrageurs introduction
  of a risk premium i ? Se - i ?

15
Interest Rate Parity

• Uncovered Interest Rate Parity - Empirical
  evidence
• Difficulties
• Assess expectations on S
• Joint test of rational behavior of investors and
  of market efficiency (ex. no bubble phenomenon)
• General result UIP does not hold
• very little empirical support
• (possibly due to the existence of a risk premium)

16
Forward Market

• The forward market for foreign exchange
• Next to arbitrageurs, another important group on
  the forex markets speculators. They
  deliberately expose themselves to exchange rate
  risk.
• Speculators will trade on the basis of the
  difference between f (forward) and se (spot
  expected) at a given time horizon.
• Trade until f se
• Hypotheses underlying this relation
• Speculators are risk neutral
• Not prevented from operating on the forward
  market
• No transaction costs

17
Forward Market

• We rational behavior hypothesis, we have
• st ste ut , ut being a random walk (mean
  zero)
• with the arbitrage relation se f
• we have st ft-1 ut (1)
• meaning ft-1 non biaised estimator of St
• (1) is the efficient market condition relating
  the actual spot exchange rate to the forward
  rate.
• Tests over market efficiency of forward rates
• Difficulty joint test, both on market
  efficiency and on fundamentals of the model
  supposed to derive se
• Methods using regressions and serial
  autocorrelation tests

18
Forward Market

• Some results of the econometrical tests
• Empirical support of existence of a risk premium
  (time-varying), but no clear model of formation
• The lagged spot rate (st-1) outperforms the
  forward rate at predicting the spot rate -gt
  abnormal profits could have been made, trading on
  the basis of the difference between the current
  spot rate and the forward rate at a given time.
• Survey data about expectations formation of
  agents
• Expected change in spot rates is not an unbiased
  predictor of actual change in the spot rate
• Agents bias their estimation of spot rates, based
  on extrapolation of recent trend -gt destabilising
  expectations on exchange rates.

19
Real Interest Rate Parity

• Real Interest Rate Parity - Definition
• Question whether capital flows ensure that real
  interest rates are equalised across countries.
• Important question for government, seeking to
  adjust real interest rates to influence behaviour
  of individual agents.
• Real interest rate parity needs PPP and UIP to
  hold.
• Therefore, very few empirical support for RIP for
  US, UK and European countries, based on
  regression analysis and graphical evidence.

20
Conclusion

• Main results of the chapter
• Serious theoretical questions on PPP theory and
  few empirical support.
• CIP theory includes the role of capital mobility
  and arbitrage. More empirical support of CIP
  while UIP does not hold empirically.
• Relationship between spot and forward rates
  suggest the existence of a time-varying risk
  premium and some irrationality of market
  participants while forming expectations of
  exchange rates.

21
Conclusion

• Important policy implications
• If agents form their expectations extrapolatively
  then a policy of leaning against the wind may
  be beneficial.
• That is, a forex market intervention attempting
  to break a trend in the market.
• The existence of a risk premium that assets
  domestic and abroad are not perfect substitutes,
  and that interest rates in any country may not be
  identical to those abroad, even with no
  particular expectations of spot rate changes.
• It also implies that sterilised intervention may
  work.