You are on page 1of 31

International Parity Relationships and Forecasting Foreign Exchange Rates

Chapter Objective:

Chapter Six

6

This chapter examines several key international parity p y relationships, p , such as interest rate parity p y and purchasing power parity.

6-0

Chapter Outline
 Interest Interest Rate Rate Parity Parity
 Covered Interest Arbitrage  Purchasing Purchasing Power Power Parity Parity  PPP Deviations and  Fisher The The Fisher Fisher Effects Effects Effects   

 International Forecasting ForecastingExchange Fisher Exchange Effects Rates Rates  Purchasing Power Parity  The Fisher Market Effects  Efficient Approach   

IRP and Exchange Rate Determination the Real Exchange Rate Reasons for Deviations from IRP Evidence on Purchasing Power Parity

The Fisher F Forecasting i Effects E Exchange h Rates R  Fundamental Approach Forecasting Exchange Rates  Technical Approach

Performance of the Forecasters

6-1

1

Interest Rate Parity
  

Interest Rate Parity Defined Covered Interest Arbitrage Interest Rate Parity & Exchange Rate Determination Reasons for Deviations from Interest Rate Parity

6-2

Interest Rate Parity Defined
 

IRP is an “no arbitrage” condition. If IRP did not hold, then it would be possible for a trader to make unlimited amounts of money exploiting the arbitrage opportunity. Since we don’t typically observe persistent arbitrage conditions, conditions we can safely assume that …almost all of the time! IRP holds.

6-3

2

Variable Definitions
iH : Interest Rate in the home country iF : Interest Rate in the foreign country S = Current spot rate for the foreign currency (in direct quote) F = 1 year forward rate for the foreign currency (in direct quote) FPH = one year forward premium from the home country’s viewpoint = (F-S) / S FPF = one year forward premium from the foreign country’s viewpoint = (S- F) / F or (1/ FPH – 1) iCH : Covered rate of interest, from the home country’s viewpoint iCF : Covered rate of interest, from the foreign country’s viewpoint (1 + i ) F$/£ = S$/£ × (1 + i$) £
6-4

Interest Rate Parity Carefully Defined
Consider two alternative one-year investments for $1 1. You could invest in the US at iH. Future value of this investment in $ will be: $1 × (1 + iH) = (1 + iH) 2. Or you could convert $1 into the foreign currency at the going spot rate (S) and invest 1/S in the foreign country at iF whose future value will be: [1/S × (1 + iH)]. In order to eliminate any exchange rate risk, you will have to sell this amount at forward rate (F) to get you money back in $: F x [1/S × (1 + iH)]

Since these investments have the same risk, they must have the same future value (otherwise an arbitrage would exist) (1 + i$) F F = S × $/ £ $/ £ (1 + iF) × = (1 + iH) (1 + i£)
6-5

S

3

Interest Rate Parity Defined Formally. that 6-7 4 . F) or indirect (SI. FI). we have: 1 + iF FI = 1 + iH SI or 1 + iH F = 1 + iF S …so so be a bit caref careful l about abo t that. y. 1 + iH F = S 1 + iF 1 + iH 1 + iF -1 = F–S S = FP Or IRP is sometimes approximated as iH – i F ≈ F – S S 6-6 Interest Rate Parity Carefully Defined  Depending upon how you quote the exchange rates. direct (S.

1 F i Country’s Foreign C ’ viewpoint i i (iCF) = (1 + i$) (1 + iH) x (1 + FP )-1 F F $/£ = S$/£ × 6-9 (1 + i£) 5 . 6-8 Covered Rate of Interest Home Country’s viewpoint (iCH) = (1 + iF) x (1 + FPH ) .Interest Rate Parity Carefully Defined  No matter how you quote the exchange rate (direct or indirect) to find a forward rate. increase the dollars by the dollar rate and the foreign currency by the foreign currency rate: FI = SI × 1 + iF 1 + iH or F= S× 1 + iH 1 + iF …be careful—it’s easy to get this wrong.

iH.00% iF = 8. Consider the following set of foreign and domestic interest rates and spot and forward exchange rates.0000 $2 0000 F = $1. It is easiest to see this in the form of an example.IRP & Covered Interest Arbitrage (CIA) CIA is possible when: iCH > iH iCF > iF When CIA is possible. an arbitrage g would exist. .9700 iH = 5.00% 6-11 6 . IRP holds when CIA is not possible: iCH = iH (1 + i$) iCF = iF F$/£ = S$/£ × (1 +i ) 6-10 £ IRP and Covered Interest Arbitrage If IRP failed to hold. Spot exchange rate for GBP 360-day forward rate for GBP US interest rate British interest rate S = $2. and FP will have to adjust to eliminate arbitrage. iF .

It is easiest to see this in the form of an example. Spot exchange rate for GBP 360-day forward rate for GBP US interest rate British interest rate S = $2.IRP and Covered Interest Arbitrage If IRP failed to hold.00% iF = 8.9100 iH = 5.00% 6-12 IRP and Covered Interest Arbitrage 6-13 7 . . an arbitrage g would exist.0000 $2 0000 F = $1. Consider the following set of foreign and domestic interest rates and spot and forward exchange rates.

0000 $2 0000 F = $2. . Spot exchange rate for BP 360-day forward rate for BP US interest rate British interest rate S = $2. Consider the following set of foreign and domestic interest rates and spot and forward exchange rates. Spot exchange rate for BP 360-day forward rate for BP US interest rate British interest rate S = $2. It is easiest to see this in the form of an example.IRP and Covered Interest Arbitrage If IRP failed to hold.00% iF = 4.0400 iH = 8.00% 6-14 IRP and Covered Interest Arbitrage If IRP failed to hold.00% iF = 4. . an arbitrage g would exist. Consider the following set of foreign and domestic interest rates and spot and forward exchange rates.090 iH = 8. an arbitrage g would exist.00% 6-15 8 . It is easiest to see this in the form of an example.000 $2 000 F = $2.

Reasons for Deviations from IRP Transactions Costs   The interest rate available to an arbitrageur for borrowing. Fb/Sa < F/S Capital Controls  Governments sometimes restrict import and export of money through taxes or outright bans. There may be bid-ask spreads to overcome. ib may exceed the rate he can lend at. 6-16 Reasons for Deviations from IRP 6-17 9 . il.

currencies should move towards the rate which equalizes the prices of an identical basket of goods and services in each country The exchange rate (direct quote) between two (S) currencies should equal the ratio of the countries’ price levels in the home (PH) and foreign (PF) country: S = (PH / (PF) Examples 6-19 10 .Purchasing Power Parity      The concept of Absolute and Relative Purchasing Power Parity (PPP) PPP and Exchange Rate Determination PPP Deviations and the Real Exchange Rate Consequences of PPP Violations Evidence on PPP 6-18 Absolute Purchasing Power Parity     A dollar should buy the same quantities of goods and services in all countries According to absolute PPP. in the long run.

50/ S= What happens if S = 1. then the price of one euro in terms of dollars should be: $1200 $1 50/ € S = € 800 = $1.Absolute Purchasing Power Parity and Exchange Rate Determination PH PF For example.S.25 or S = 1. if an ounce of gold costs $1200 in the U.75? 6-20 Does PPP Hold? More Examples 6-21 11 . and € 800 in Europe.

Evidence on Absolute PPP  Absolute PPP probably doesn’t hold precisely in the h real l world ld for f a variety i of f reasons:  Tradable and non-tradable factors of production   Haircuts cost 10 times as much in the developed world as in the developing world. as well as tariffs and quotas can lead to deviations from PPP. Film. is a highly standardized commodity that is actively traded across borders. 6-22 PPP: Evidence 6-23 12 . on the other hand.  Shipping costs.  Relative PPP-determined exchange rates can provide a more valuable benchmark.

Does PPP Hold? The Case of Big Mac 6-24 Relative Purchasing Power Parity   Even if the dollar does not buy the same basket of goods in other countries. the purchasing power of the h d dollar ll in i these h countries i could ld remain i stable bl over time. We can show that according to Relative PPP:   If two countries have different inflation rates. The “real” exchange rate will remain constant 6-25 13 . then the exchange rates between the two countries will adjust to maintain equality of relative purchasing power for the citizens of both countries.

or rate of change. if an ounce of gold costs $1200 in the U.50/ S= What happens if S = 1. 1 year from now. in the spot rate Sr= real spot rate 6-26 Absolute Purchasing Power Parity and Exchange Rate Determination PH PF For example. based on PPP e = (S1/S) – 1 = The actual percentage change.75? 6-27 14 .25 or S = 1.1] H = Inflation rate in the home country F = Inflation rate in the foreign country E(S1) = Expected spot rate.S. in the spot rate.Variable Definition S= Current spot rate (price of foreign currency) in direct quote S1 = Actual spot rate. based on PPP E(e) = [E(S1)/S] – 1 = The expected percentage change. then the price of one euro in terms of dollars should be: $1200 $1 50/ € S = € 800 = $1. 1 year from now F = 1-year forward rate FP = the forward premium = [(F-S) / S] = [(F/S) . or rate of change. and € 800 in Europe.

50 €1. the euro is expected to appreciate by 1.50×(1. (H) is expected to be 5% in the next year and 3% in the euro zone(F).00×(1.Purchasing Power Parity and Exchange Rate Determination    Suppose the spot exchange rate (S) is $1.50×(1.5291 .94% in the spot market by the end of the year: E(S1) = S $1.019 = 1.05) 50 (1 05) $1.00 = 1.00×(1.03 1 + F Relative PPP states that the rate of change in the exchange rate is equal to differences in the rates of inflation—roughly 2% Also remember that E(S1) = F So that: expected rate of change in the exchange rate = forward premium.575 $1 575 = $1.00 If the inflation rate in the U.05 1 + H = 1.50 = €1.03) $1.S.03) €1.50×(1.94% $1.00×(1. or E(e) = FP 6-29 15 .50 6-28 Purchasing Power Parity and Exchange Rate Determination  Because of the inflation differential.03 E(e) = [E(S1)/S – 1] = $1.05) €1. Then the expected exchange rate in one year E(S) should be such that $1.05) = €1.5291 E(S1) = $1 = €1.1 = .03) $1.

50 to $1.50 to $1.50 and US inflation rate is 5% while the inflation rate is 3% in the euro zone If the spot rate next year turns out to be 1.52.54.52*(1.F E(S1) = S [1 + E(e)] -1 6-30 “Real” Exchange Rate Real exchange rate is the spot rate adjusted for inflation. it actually depreciated in “real” terms from $1.491 • We can say that although the spot rate for € appreciated in “nominal” terms from $1. 1 52 the real exchange rate is: 1. after adjusting for inflation.Relative Purchasing Power Parity  According to Relative PPP: E(S1) 1 + H = S 1 + F 1 + H E(e) = 1 + F Approximately: pp y E(e) ( ) = H . zone. real exchange rates should remain constant Suppose the US the current spot rate for € is 1. let us call it Sr .03/1. Sr = S1 Under PPP.491 • This would weaken the US’s competitive position against Europe 6-31 16 . It is supposed to tell us if a foreign currency has appreciated or depreciated.05) = $1.

PPP & Competitiveness We can also use PPP to determine the competitiveness of the home country’s currency q = = = E(S1)/S1 q = 1: Competitiveness of home country is unchanged q < 1: Competitiveness of home country has improved q > 1: Competitiveness of home country has deteriorated 6-32 PPP Conditions Summarized PPP is Violated PPP Holds Foreign g currency y has Foreign g currency y has appreciated (USD has depreciated (USD has depreciated) in “real” appreciated) in “real” terms terms No Change US exports more competitive US exports less competitive S1 = E(S1) e = E(e) S = Sr q=1 6-33 S1 > E(S1) e > E(e) S > Sr q<1 S1 < E(S1) e < E(e) S< Sr q>1 17 .

05] q is equal to: [1+E(e)] / [1 + e ] = E(S1)/S1 The “real” rate (Sr) has: In real terms. F = 0.03/1.05 Inflation rate in the Europe is 3%.88 higher .2.5107 0. S = 0. SF has: US’s competitiveness has: 6-35 lower . .1 = 1.02941)= $0. at the end of the year.5291.444 4 444 % $0.994 increased appreciated improved If.9417 % To maintain relative PPP.875. the expected spot exchange rate for €. € has: US’s competitiveness has: 6-34 PPP: EXAMPLE 2      Inflation rate in the US is 5%. the e expected pe percentage ce tage c change a ge i in t the e spot exchange rate for SF.5291 per € $1.05) / (1. H = 0.52 lower 1 333 % 1.4910 1.50.86 Compared to E(S1) of $0.2. 1 year latter the actual spot rate.03) .9051 0.50 To maintain relative PPP PPP. E(e) = (1.90.08 Current spot rate for SF is $0.017 decreased depreciated deteriorated 18 .027 $1. S1 is Actual % change in S: e = (S1/S) -1 1 The “real” rate for €. S1 is Actual % change in S: e = (S1/S) -1 1 The “real” rate for SF.778 % To maintain relative PPP.1 = . Sr = S1 *[1. S1 for SF turns out to be $0.9929 increased appreciated improved $1.PPP: EXAMPLE 1      Inflation rate in the US is 5%.4.222 2 222 % $0.05 Inflation rate in the Switzerland is 2%. at the end of the year. S = 1. the expected percentage change in the spot exchange rate for €.019417)= $1. the expected spot exchange rate for SF.0060 decreased depreciated deteriorated If.8846 1.50 ( 1 + 0. Sr =S1*[1.333 $1. F = 0. E(S1) = $1. S1 for € turns out to be Compared to E(S1) of $1.90 To o maintain relative e ve PPP. 1 year latter the actual spot rate.05) / (1. H = 0.03 Current spot rate for € is $1.05] q is equal to: [1+E(e)] / [1 + e ] = E(S)/S1 The “real” rate (Sr) has: In real terms. E(S1) = $0.875 per SF $0.54 higher 2 027 % 2.08) .90 ( 1 + 0. E(e) = (1.08/1.

Purchasing Power Parity and Interest Rate Parity  Notice that the PPP & IRP equations are equal because E(S) = F or E(e) = FP: IRP PPP F 1 + iH E(S) 1 + H = = 1+i = S S 1 + F F E(e) = 1 + H -1 = 1 + F 1 + iH -1 = FP 1 + iF 6-36 PPP: Evidence 6-37 19 .

Expected Rate of Change in Exchange Rate as Inflation Differential  We could also reformulate our equations as inflation or interest rate differentials: F($/€) 1 + $ = S($/€) 1 + € F($/€) – S($/€) 1 + $ 1 + $ 1 + € = –1= – S($/€) 1 + € 1 + € 1 + € E(e) = 6-38 F($/€) – S($/€)  – € ≈ $ – € = $ S($/€) 1 + € Fisher Effect The nominal interest rate is composed of a real interest rate and an expected inflation rate. Expected inflation:  (1 + i) = (1 + ρ) (1 + ) i = ρ +  + ρ Approximately: i = ρ +  If real rates are equal across countries. Nominal interest rate: i. or: ρH = ρF Then: (1 + iH) / (1 + iF) = (1 + H) / (1 + F) Approximately : iH .iF = H . Real rate: ρ.F 6-39 20 .

(3) Therefore all nominal interest rate differences must be due to inflation differences 6-41 21 . (2) All investors have the same real rate of return worldwide.International Fisher Effect (IFE)    The concept of IEF IFE Conditions Deviations of from IFE: uncovered rates of interest: from the home and foreign country’s view point 6-40 International Fisher Effect (IFE)  In an integrated global money and capital markets: (1) Domestic fisher effect holds in each country.

6-42 IFE: Terminology iH = Nominal interest rate for the home country g country y iF = Nominal interest rate for the foreign S = Current spot rate (direct quote) for the foreign currency (in home currency units) S1 = Next year’s spot rate (direct quote) for the foreign currency 6-43 22 .International Fisher Effect (IFE)  The exchange rate of a country with a higher (lower) interest rate than its trading partner should depreciate (appreciate) by the amount of the interest rate difference to maintain equality of real rates of return.

Investing the FOREIGN CURRENCY at the FOREIGN INTEREST RATE (iF).Uncovered Rate: Home County’s View point   The uncovered rate from the home county’s point of view (iUH) is the rate earned by the holders of dollars by: 1. and 2. and 3.S1) / S1  The rate of interest you earn in the home country (US) = iH iUF = (1 + % change in IQ)*(1 + iH) – 1 You calculate it as: Profit making strategy : If iUF > iF then borrow in foreign currency and invest in dollars If iUF < iF then borrow in dollars and invest in foreign currency If iUF = iF then you cannot make any profit 6-45 23 . Converting FOREIGN CURRENCY back into DOLLARS at maturity using the future spot exchange rate (S1) This return is affected by two factors:  whether the foreign currency appreciates or depreciates against the dollar = % change in direct quote (DQ) = (S1 . Converting DOLLARS back into FOREIGN CURRENCY at maturity using the future spot exchange rate (S1) This return is affected by two factors:  whether the US Dollars appreciates or depreciates against the foreign currency = % change in indirect quote (IQ) = (S0 . (S) and 2. Investing the DOLLARS at the US INTEREST RATE (iH). and 3.S) / S  The rate of interest you earn in the foreign country = iF iUH = (1 + % change in DQ)*(1 + iF) – 1 You calculate it as: Profit making Strategy: If iUH > iH then borrow in dollars and invest in foreign currency If iUH < iH then borrow in foreign currency and invest in dollars If iUH = iH then you cannot make any profit 6-44 Uncovered Rate: Foreign County’s View point   The uncovered rate from the foreign county’s point of view (iUF) is the rate earned by the holders of foreign currency by: 1. Converting DOLLARS into FOREIGN CURRENCY today at the current spot exchange rate (S). Converting FOREIGN CURRENCY into DOLLARS today at the current spot exchange rate (S).

iF According to IFE IFE. should be: E(S1) = S [1 + E(e)]  6-46 Uncovered Rate and IFE: Summarized If iUH > iH or iUF < iF then investors will profit if they: • • • • • borrow in the home country (US) convert the $ loan amount into foreign currency invest in the foreign capital market at the h end d of f the h b borrowing/investment i /i period i d convert the h foreign f i currency back b k into domestic currency ($) and pay off the domestic (US) loan If this continues then: S↑. E(S1)↓. E(S1)↑. until iUH = iH or iUF = iH. iF↓. now E(S1). or IFE holds If iUF > iF or iUH < iH then investors will profit if they: • • • • • borrow in the foreign country convert the loan amount from foreign currency into domestic currency ($) invest in the domestic (US) capital market at the end of the borrowing/investment period convert the domestic currency ($) back into foreign currency and pay off the foreign loan If this continues then: S↓. until iUH = iH or iUF = iH. E(e): E(e)= (1 + iH) / (1 + iF) – 1 Approximately: E(e)= iH .IFE Conditions    According to IFE one should not be able to make money by consistently borrowing in one country and investing in another These conditions are met when: iUH = iH or iUF = iF According to IFE the above conditions will hold only when the expected percentage change in the spot rate. or IFE holds 6-47 24 . iF↑. the expected spot rate 1 year from now. iH↓. iH↑.

37 / € What happens if you believe (predict) that S1 will be $1. iF = 3% Current spot rate for SF (S)= $0.IFE : Example 1       Interest rate in US.85 ( 1 + 0.09) .883 / SF What happens if you believe (predict) that S1 will be $0.1. quote for € should be: E(e) = (1.1 = 3.40 ( 1 .0.40 According to IFE.39 ?  You could make money by borrowing in $ and investing in €  Can you show how? What happens if you believe (predict) that S1 will be $1. S = $1. the expected spot rate for SF at the end of the year should be: E(S1) = $0.07) / (1.0183) = $ 1.85 According to IFE. the percentage change in exchange rate.06) / (1.8845% According to IFE.83486% According to IFE.03) . iH = 7 % & Euro zone interest rate. based on direct quote.1 = . quote SF should be: E(e) = (1. iH = 7% & Interest rate in Switzerland.87 ?  You could make money by borrowing in SF and investing in $  Can you show how? 6-49 25 . iF = 9 % Current spot rate for €.0288) = $0. based on direct quote.90 ?  You could make money by borrowing in $ and investing in FF  Can C you show h how? h ? What happens if you believe (predict) that S1 will be $0. the expected spot rate for € at the end of the year should be: E(S1) = $1. the percentage change in exchange rate.35 ?  You could make money by borrowing in € and investing in $  Can you show how? 6-48 IFE : Example 2       Interest rate in US.

Approximate Equilibrium Exchange Rate Relationships E(e) ≈ IFE ≈ FEP ≈ PPP ≈ IRP ( iH – iF) F–S S E(H – F) 6-50 Exact Equilibrium Exchange Rate Relationships E ( S1 ) S PPP IRP IFE FEP 1 + iH 1 + iF F S E(1 + H) E(1 + F) 6-51 26 .

rate 1 year from now now. based on PPP E(e) = [E(S1)/S] – 1 = The expected percentage change.1] from the foreign country’s view point H = Inflation rate in the home country F = Inflation rate in the foreign country ρ = Real rate of interest E(S1) = Expected spot rate. in the spot rate. in the spot rate Sr= real spot rate iH = Nominal interest rate for the home country iF = Nominal interest rate for the foreign country Formula: Purchasing Power Parity (PPP) Exact relationship: E(e) =(1 (1 + πH) / (1 + πF) .1 Approximate relationship: E(e) = πH . or rate of change.Variable Definitions S= Current spot rate (price of foreign currency) in direct quote S1 = Actual spot rate. 1 year from now F = 1-year forward rate FPH = the forward premium = [(F-S) / S] = [(F/S) . or rate of change.πF S1 = S0 * [ 1 + E(e) ] SR = S1 *(1 + πF) / (1 + πH) Fisher i Equation: i (1 + i) = (1 + ρ) (1 + ) i = ρ +  + ρ Approximately: i = ρ +  27 . based on PPP e = (S1/S) – 1 = The actual percentage change.1] from the home country’s view point FPF = the forward premium = [(S-F) / F] = [(S/F) .

Formula: International Fisher Effect (IFE) Fisher Equation: (1 + i) = (1 + ρ) (1 + ) i = ρ +  + ρ Approximately: i = ρ +  iuh : Uncovered rate of return. home country’s view point icf= Covered rate of return.1 The IFE relationship holds when: E(e)= (1 + iH) / (1 + iF) – 1 Approximately: E(e)= iH – iF S1 = S0 * [1 + E(e)] Formula: Interest Rate Parity (IRP) Calculating the covered rate of returns (home & foreign country’s view point) ich= Covered rate of return.S0) / S0 % change in IQ (indirect quote) = [1 /(1+ % change in DQ] . home country’s viewpoint iuf : Uncovered rate of return. foreign country’s view point ich = (1 + if) (1 + FPh) – 1 icf = (1 + ih) (1 + FPf) – 1 FPh = (1 + ih)/(1 + if) – 1 S1= S0 * ( 1 + FPh) The IRP relationship holds when the expected forward premium from the home country’s point of view (FPh ): 28 . foreign country’s viewpoint iuh = (1 + if) (1 + % change in DQ ) – 1 iuf = (1 + ih) (1 + % change in IQ ) – 1 % change h i in DQ (direct (di t quote)= t ) (S1 .

The Hamburger Standard: Further Discussion 6-56 29 .

30 .

31 .