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The Foreign Exchange Market
The Foreign Exchange
Market

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Slide

8-1

Key Issues

What is the form and function of the foreign exchange

market?

What is the difference between spot and forward exchange rates?

How are currency exchange rates determined?

What is the role of the foreign exchange market in

insuring against foreign exchange risk?

What are the merits of different approaches toward exchange rate forecasting?

Why are some currencies not always convertible into

other currencies?

How is countertrade used to mitigate problems associated with an inability to convert currencies?

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Introduction

1. Introduction a. The Currency Market:

where money denominated in one

currency is bought and sold with money

denominated in another currency

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Introduction

b. International Trade and capital Transactions:

facilitated with the ability to transfer

purchasing power between countries

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• C. Location: 1. OTC type: No specific location 2. Most trades by phone, telex, or

C. Location:

1. OTC type: No specific location

2. Most trades by phone, telex, or

SWIFT (Society for worldwide Interbank Financial Telecommunications)

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Definition of foreign exchange

Deposits, credits and balances payable in foreign currency • Drafts, travellers’ cheques, letter of credit or bill of exchange expressed or drawn in Indian currency but payable in foreign currency • Drafts, travellers’ cheques, L/Cs, etc. drawn by banks, institutions or persons outside India but payable in Indian currency The above definition is as per FEMA (1999)

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8-1

Foreign Exchange

The foreign exchange market

Is the market where one buys (or sells) the currency of country A with (or for) the currency of country B

A currency exchange rate

Is simply the ratio of a unit of currency of country A to a unit of the currency of country B at the time of the buy or sell transaction

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Exchange Rates and

International Transactions

An exchange rate can be quoted in two ways:

Direct

The price of the foreign currency in terms of dollars

Indirect

The price of dollars in terms of the foreign currency

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The Foreign Exchange Market

Exchange rates are determined in the foreign exchange market.

The market in which international currency trades take place

The Actors

The major participants in the foreign exchange market are:

Commercial banks International corporations Nonbank financial institutions Central banks

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Factors affecting exchange rate

Major banks that act as market-makers always give two-way quotes; gives depth

and volume to the market Fundamental reasons Technical reasons Speculation

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Fundamental reasons

Balance of payments->surplus- >appreciation

Growth rate of the economy-> higher growth->depreciation of currency

Fiscal policy-> financing of fiscal deficit influences exchange rate

Monetary policy->loose monetary policy-> depreciation of exchange rate

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Technical reasons

Freedom or restrictions on capital movements can affect exchange rates to a

large extent Among other factors there are:

Huge trade surpluses of oil exporting countries Capital moving from low-yielding currencies to high yielding currencies (interest differential)

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Speculation

Self-fulfilling prophecies

Anticipation of depreciation of a currency can cause dealers to sell that currency

Speculation serves to provide depth and liquidity to the forex market

Acts as a cushion as well- contrarian traders exist in the market

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Types of exchange rate (1)

Ready/cash- Settlement of funds on the same day (date of the deal).

Tom- Settlement of funds takes place on the next working day of the date of the deal

Spot- Settlement of funds takes place on the second working day following the date of

the deal

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Types of exchange rate (2)

Forward- Delivery takes place on any day after the date of the deal

In the forex market all rates that are quoted are generally spot rates

When delivery takes place beyond the spot date then it is a forward transaction and the

forward rate is applicable

Forward rate = Spot rate + Premium (- discount)

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Slide

8-2

The Foreign Exchange Market

Currency conversion in the foreign exchange market

Is necessary to complete private and commercial transactions across borders

A tourist needs to pay expenses on the road in local currency

A firm

• Buys/sells goods and services in the other country’s local

currency

Uses the foreign exchange market to invest excess funds

Is used to speculate on currency movements

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Slide

8-3

The Foreign Exchange Market

Minimizes foreign exchange risk (unpredictable rate swings) There are different ways to trade currencies

– Spot exchange rates: the day’s rate offered by a

dealer/bank Forward exchange rates:

Agreed in advance rates to buy/sell a currency on a future date Usually quoted 30, 90, 120 days in advance

• The market is “open” 24 hours…

• Arbitrage: buying low and selling high … given

slightly different exchange rate quotes in one location vs another (e.g., London vs Tokyo)

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PART

II.

ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET

I

.

PARTICIPANTS IN THE

FOREIGN EXCHANGE

MARKET

A. Participants at 2 Levels

  • 1. Wholesale Level (95%)-

major banks

  • 2. Retail Level

- business

customers.

ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET

  • B. Two Types of Currency Markets

    • 1. Spot Market:

      • - immediate transaction

      • - recorded by 2nd

business day

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ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET

  • 2. Forward Market: - transactions take place at a

specified future date

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ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET

  • C. Participants by Market 1. Spot Market

    • a. commercial banks

    • b. brokers

    • c. customers of commercial and central banks

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ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET

  • 2. Forward Market

    • a. arbitrageurs

    • b. traders

    • c. hedgers

    • d. speculators

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ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET

II.

CLEARING SYSTEMS

A. Clearing House Interbank

Payments System

(CHIPS)

- used in U.S. for electronic

fund transfers.

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ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET

B.

FedWire

  • - operated by the Fed

  • - used for domestic transfers

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ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET

III.

ELECTRONIC TRADING

A. Automated Trading

  • - genuine screen-based market

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ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET

B.

Results:

  • 1. Reduces cost of trading

  • 2. Threatens traders’

oligopoly of information

  • 3. Provides liquidity

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ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET

IV.

SIZE OF THE MARKET

A. Largest in the world

1995: $1.2 trillion daily

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ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET

  • B. Market Centers (1995):

London = $464 billion

daily

New York= $244 billion

daily

Tokyo = $161 billion daily

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PART III.

THE SPOT MARKET

  • I. SPOT QUOTATIONS A. Sources

    • 1. All major newspapers

    • 2. Major currencies have

four different quotes:

  • a. spot price

  • b. 30-day

  • c. 90-day

  • d. 180-day

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THE SPOT MARKET

  • B. Method of Quotation

    • 1. For interbank dollar

trades:

  • a. American terms example: $.5838/dm

Dm- duetsche mark

  • b. European terms example: dm1.713/$

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THE SPOT MARKET

  • 2. For nonbank customers: Direct quote gives the home currency price of one unit of foreign currency. EXAMPLE:

Ff- French franc

dm0.25/FF

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THE SPOT MARKET

  • C. Transactions Costs

    • 1. Bid-Ask Spread used to calculate the fee charged by the bank

Bid = the price at which the bank is willing to buy

Ask = the price it will sell

the currency

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THE SPOT MARKET

  • 4. Percent Spread Formula (PS):

P S

Ask

Bid

Ask

x100

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THE SPOT MARKET

  • D. Cross Rates

    • 1. The exchange rate

between 2 non - US$

currencies.

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THE SPOT MARKET

  • 2. Calculating Cross Rates

When you want to know what the dm/cross rate is, and you know dm2/US$ and .55/US$

then dm/= dm2/US$ .55/US$ = dm3.636/

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THE SPOT MARKET

  • E. Currency Arbitrage

    • 1. If cross rates differ from one financial center to another, and profit opportunities exist.

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THE SPOT MARKET

  • 2. Buy cheap in one int’l market,

sell at a higher price in

another

  • 3. Role of Available Information

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THE SPOT MARKET

  • F. Settlement Date Value Date:

1. Date monies are due

2. 2nd Working day after date of

original transaction.

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THE SPOT MARKET

  • G. Exchange Risk

1. Bankers = middlemen

  • a. Incurring risk of adverse exchange rate moves.

  • b. Increased uncertainty

about future exchange rate requires

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THE SPOT MARKET

1.)

Demand for higher risk premium

2.)

Bankers widen bid-ask

spread

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PART II. MECHANICS OF SPOT TRANSACTIONS

SPOT TRANSACTIONS: An Example

Step 1.

Currency transaction: verbal

agreement, U.S. importer specifies:

  • a. Account to debit (his acct)

  • b. Account to credit (exporter)

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MECHANICS OF SPOT

TRANSACTIONS

Step 2.

Bank sends importer contract note including:

  • - amount of foreign

currency

  • - agreed exchange rate

  • - confirmation of Step 1.

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MECHANICS OF SPOT

TRANSACTIONS

Step 3.

Settlement

Correspondent bank in Hong

Kong transfers HK$ from

nostro account to exporter’s.

Value Date.

U.S. bank debits importer’s account.

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PART III.

THE FORWARD MARKET

I. INTRODUCTION

  • A. Definition of a Forward

Contract

an agreement between a bank and a customer to deliver a specified amount of currency against another currency at a specified future date and at a fixed exchange rate.

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THE FORWARD MARKET

  • 2. Purpose of a Forward:

Hedging

the act of reducing exchange

rate risk.

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THE FORWARD MARKET

  • B. Forward Rate Quotations

    • 1. Two Methods:

      • a. Outright Rate: quoted to

commercial customers.

  • b. Swap Rate: quoted in the

interbank market as a discount or premium.

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THE FORWARD MARKET

CALCULATING THE FORWARD

PREMIUM OR DISCOUNT

= F-S

x

12

x

100

S

n

where F = the forward rate of exchange

S = the spot rate of exchange

n = the number of months in the

forward contract

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THE FORWARD MARKET

C. Forward Contract Maturities

  • 1. Contract Terms

    • a. 30-day

    • b. 90-day

    • c. 180-day

    • d. 360-day

  • 2. Longer-term Contracts

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  • 3. Four theories

.

     

Fisher

 

Difference in

Theory

Exp. difference in

interest rates

 

inflation rates

  • 1 + r

 

1 + i SFr

  • 1 + r $

1 + i $

Rate

   

parity

 

Difference between

 

Expected change

forward & spot rates

in spot rate

 

F /$

Exp. Theory

E(s /$ )

s /$

of forward

S /$

rates

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Interest

Relative PPP

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Theory #1: Purchasing power

parity

Theory #1: Purchasing power parity Versions of PURCHASING POWER PARITY Law of One Price Absolute PPP

Versions of

PURCHASING

POWER

PARITY

Theory #1: Purchasing power parity Versions of PURCHASING POWER PARITY Law of One Price Absolute PPP
Law of One Price
Law of One Price
Absolute PPP
Absolute PPP
Relative PPP
Relative PPP

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The Law of One Price

   
 

A commodity will have the same price in terms of common currency in every country

 

In the absence of frictions (e.g. shipping costs,

 

tariffs, )

..

Example

Price of wheat in France (per bushel): P

 

Price of wheat in U.S. (per bushel): P $ S /$ = spot exchange rate

P = s /$ P $

 

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The Law of One Price, continued

Example:

Price of wheat in France per bushel (p ) = 3.45 Price of wheat in U.S. per bushel (p $ ) = $4.15

S /$ = 0.83215

(s $/ = 1.2017)

Dollar equivalent price

of wheat in France = s $/ x p

 

= 1.2017 $/x 3.45 = $4.15

and

demand forces help restore the equality

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When law of one price does not hold, supply

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Absolute PPP

 
 

Extension of law of one price to a basket of goods

Absolute PPP examines price levels

 

Apply the law of one price to a basket of goods

with price P and P US (use upper-case P for the

price of the basket):

S /$ = P / P US

 

where

P = i (w FR,i p ,i ) P US = i (w US,i p US,i )

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Absolute PPP

If the price of the basket in the U.S. rises relative to the price in Euros, the U.S. dollar depreciates:

May 21 : s /$ = P / P US

= 1235.75 / $1482.07 = 0.8338 /$

May 24: s /$ =

1235.75 / $1485.01 = 0.83215 /$

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Relative PPP

   
 

Absolute PPP:

 

P = s /$ P $

 

For PPP to hold in one year:

 

P (1 + i ) = E(s /$ ) P $ (1 + i $ ),

 

or:

P (1 + i ) = s /$ [E(s /$ )/s /$ )] P $ (1 + i $ )

 

Using absolute PPP to cancel terms and rearranging:

Relative PPP:

 

1 + i = E(s /$ )

 

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1 + i $

s /$

 

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Relative PPP

Main idea The difference between (expected) inflation rates equals the

(expected) rate of change in exchange rates:

1 + i = E(s /$ )

1 + i $

s /$

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Deviations from PPP

Deviations from PPP Why does PPP not hold? Simplistic model Imperfect Markets Statistical difficulties © 2004
Why does PPP not hold?
Why does
PPP
not
hold?
Simplistic model
Simplistic model
Imperfect Markets
Imperfect Markets
Statistical difficulties
Statistical difficulties

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Deviations from PPP

 

Simplistic model

Transportation costs Tariffs and taxes Consumption patterns differ Non-traded goods & services

 

Imperfect Markets

Sticky prices Markets don’t work well

Construction of price indexes

Statistical difficulties

  • - Different goods

  • - Goods of different qualities

Deviations from PPP Simplistic model  Transportation costs  Tariffs and taxes  Consumption patterns differ
Deviations from PPP Simplistic model  Transportation costs  Tariffs and taxes  Consumption patterns differ
Deviations from PPP Simplistic model  Transportation costs  Tariffs and taxes  Consumption patterns differ

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Summary of theory #1:

.

Exp. difference in

 

inflation rates

  • 1 + i

  • 1 + i $

 

Relative PPP

Expected change in spot rate E(s /$ )

 

S /$

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Theory #2: Interest rate parity

Main idea: There is no fundamental advantage to borrowing or lending in one currency over

another

This establishes a relation between interest rates, spot exchange rates, and forward exchange rates

Forward market: Transaction occurs at some point in future

BUY: Agree to purchase the underlying currency at a predetermined exchange rate at a specific time in the future

SELL: Agree to deliver the underlying currency at a predetermined exchange rate at a specific time in the future

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Example of a forward market transaction

Suppose you will need 100,000in one year

Through a forward contract, you can commit to lock in the exchange rate

f $/ : forward rate of exchange

Currently, f $/ = 1.19854

1 buys $1.19854

1 $ buys 0.83435

At this forward rate, you need to provide $119,854 in 12 months.

© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Interest Rate Parity START (today) END (in one year) r $ =2.24% $117,228 $117,228  1.0224
Interest Rate Parity
START (today)
END (in one year)
r $ =2.24%
$117,228
$117,228  1.0224 = $119,854
(Invest in $)
s €/$ =0.83215
One year
=0.83435
f €/$
(Invest in €)
$117,228  0.83215 = 97,551€
97,551€  1.0251 = 100,000€
r € =2.51%

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Interest rate parity

Main idea: Either strategy gets you the 100,000when you need it.

This implies that the difference in interest rates must reflect the difference between

forward and spot exchange rates

Interest

Rate Parity:

1 + r € = f €/$ 1 + r $ s €/$
1 + r € = f €/$
1 + r $
s €/$

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Interest rate parity example

Suppose the following were true:

U.S Dollar

Euro

12 month

interest rate Spot rate

Forward rate

2.24%

2.70%

1.2017 / $ 1.19854 / $

Does interest rate parity hold?

Which way will funds flow?

How will this affect exchange rates?

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Evidence on interest rate parity

Generally, it holds

Why would interest rate parity hold better than PPP?

Lower transactions costs in moving currencies

than real goods

Financial markets are more efficient that real

goods markets

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Summary of theories #1 and #2:

 

.

Difference in

 
 

interest rates

  • 1 + r

  • 1 + r $

Interest

 
 

Rate

parity

 

Difference between

forward & spot rates

 

f r/$

s /$

Exp. difference in inflation rates

  • 1 + i

  • 1 + i $

   

Expected change in spot rate E(s /$ )

s /$

Relative PPP

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Theory #3: The Fisher condition

Main idea: Market forces tend to allocate resources to their most productive uses

So all countries should have equal real rates of interest

Relation between real and nominal interest rates:

(1 + r Nominal ) = (1 + r Real )(1 + i )

(1 + r Real ) = (1 + r Nominal ) / (1 + i )

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Example of capital market equilibrium

Fisher condition in U.S. and France:

(1 + r $(Real) ) = (1 + r $ ) / (1 + i $ ) (1 + r (Real) ) = (1 + r ) / (1 + i )

If real rates are equal, then the Fisher condition implies:

1 + r € 1 + r $ = 1 + i € 1 + i
1 + r €
1 + r $
=
1 + i €
1 + i $

The difference in interest rates is equal to the expected difference in inflation rates

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Summary of theories 1-3:

     

Fisher

 

.

Difference in

Theory

Exp. difference in

interest rates

 

inflation rates

  • 1 + r

 
  • 1 + i

  • 1 + r $

  • 1 + i $

   

Rate

 

parity

   
 

Difference between

 

Expected change

forward & spot rates

in spot rate

 

f /$

E(s /$ )

s /$

s /$

Interest

Relative PPP

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Theory #4: Expectations theory of

forward rates

Main idea:

The forward rate equals expected spot exchange

rate

f /$ = E(s /$ )

Expectations theory of forward rates:

f €/$ = E(s €/$ ) s €/$ s €/$
f €/$ = E(s €/$ )
s €/$
s €/$

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Expectations theory of forward rates

With risk, the forward rate may not equal the spot rate

Wait six months and convert to $

Group 1: Receive in six months, want $

Sell forward

or

• With risk, the forward rate may not equal the spot rate • Wait six months
• With risk, the forward rate may not equal the spot rate • Wait six months

Group 2: Contracted to pay out in six months

Wait six months and convert $ to

Buy forward

or

If Group 1 predominates, then E(s /$ ) < f /$

) >

If Group 2 predominates, then E(s

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f /$

/$

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Takeaway: Summary of all four

theories

.

     

Fisher

 

Difference in

Theory

Exp. difference in

interest rates

 

inflation rates

  • 1 + r

 
  • 1 + i

  • 1 + r $

  • 1 + i $

Rate

   

parity

 

Difference between

 

Expected change

forward & spot rates

in spot rate

 

f /$

Exp. Theory

E(s /$ )

s /$

of forward

s /$

Interest

rates

Relative PPP

INTEREST RATE PARITY

THEORY

  • 2. The forward premium or discount equals the interest rate differential. where

(F - S)/S

= (r h - r f )

r h =

the home rate

r f = the foreign rate

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INTEREST RATE PARITY

THEORY

  • 3. In equilibrium, returns on currencies will be the same i. e. No profit will be realized

and interest parity exists

which can be written

(1

+ r h ) =

F

 
(1 + r ) = F (1 + r ) S

(1

+ r f )

S

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INTEREST RATE PARITY

THEORY

  • B. Covered Interest Arbitrage

    • 1. Conditions required : interest rate

differential does not equal the forward

premium or discount.

  • 2. Funds will move to a country with a more attractive rate.

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INTEREST RATE PARITY

THEORY

 

3.

Market pressures develop:

  • a. As one currency is more

demanded spot and sold forward.

  • b. Inflow of fund depresses interest

rates.

  • c. Parity eventually reached.

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INTEREST RATE PARITY

THEORY

C.

Summary:

Interest Rate Parity states:

  • 1. Higher interest rates on a currency offset by

forward

discounts.

  • 2. Lower interest rates are

offset by forward

premiums.

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Slide

8-4

Prices and Exchange Rates

The law of one price:

In competitive markets free of transportation costs and trade barriers, identical products sold in different

countries must sell for the same price when their

price is expressed in the same currency

Purchasing Power Parity (PPP):

If the law of one price holds for all goods and services, the PPP exchange rate can be found by comparing the prices of identical products in different countries

Changes in relative prices will change exchange rates ...

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© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Slide

8-5

Money Supply and Currency Value

Changes in relative prices in two countries will

change the exchange rate of their currencies; the

country with the highest price inflation should

see its currency decline in value.

Relative inflation rate levels and trends can

predict relative exchange rate movements

Inflation happens when the quantity of money in

circulation rises faster than the stock of goods

and services; money supply growth is related to

currency value

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Slide

8-6

Interest Rates and Exchange Rates

Interest rates reflect expectations about likely

future inflation rates;

high interest rates reflect high inflation expectation

Fisher Effect:

i = r + I

i: “nominal” interest rate in a country • r: “real” interest rate I: inflation over the period the funds are to be lent

International Fisher Effect: (S 1 -S 2 )/S 2 X 100 = i $ - i ¥

For any two countries the spot exchange rate should change in an equal amount but in the opposite direction to the difference

in nominal interest rates between the two countries

S 1 :

spot rate at time 1, S 2 : spot rate at time 1; i $ , i ¥ : nominal interest

rates in the US and Japan

McGraw-Hill/Irwin

© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Slide

8-7

Exchange Rate Forecasting

The efficient market school

Prices reflect all available public information

The inefficient market school

Prices do not reflect all available public

information

Approaches to forecasting future movements

Fundamental analysis: predictions with

econometric models based on economic theory

Technical analysis: extrapolation/interpretation

of past trends assuming they predict future

McGraw-Hill/Irwin

© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Slide

8-8

Convertibility

Convertibility and government policy

Currency freely convertible: residents/non-residents allowed

to purchase unlimited amounts of a foreign currency with the

local currency

Currency not freely convertible: residents/non-residents not

allowed to purchase unlimited amounts of a foreign currency with the local currency

Countertrade

Barter-like agreements by which goods and services can be traded for other goods and services Used to get around the non-convertibility of currencies

McGraw-Hill/Irwin

© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.