Foreign Exchange

Purchase and sale of national currencies

Huge market
$4 trillion per day (April 2007),
much growth recently
Compared with US Treasury market = $300 billion
NYSE < $10 billion

Comprised of
$1.005 trillion
$2.076 trillion in derivatives, ie
$362 billion in outright forwards
$1.714 trillion in forex swaps

Concentrated in few centers and few

currencies

Huge growth in daily turnover

Global Foreign Exchange Market

Turnover
(average daily turnover)

Currency Turnover

Most Traded Currencies

Exchange Rates

Spot versus forward exchange rates

Nominal exchange rate
A forward contract refers to a
transaction for delivery of foreign
exchange at some specified date in the
future.
Used to hedge currency risk

Forward premium

Yen-dollar Spot rate

Dollar Price of a Euro, Spot

Forward versus futures

Forwards sold by commercial banks, otc
Futures sold in organized exchanges
Originated in 1972 in the Merc
Clearinghouse, currencies need not be
delivered
Contracts settled in cash
Forward markets larger but futures markets
more liquid

Options
Right to buy or sell at set price (strike price)

Covered Interest Parity

Covered transactions eliminate currency risk
Let i and i* be the domestic and foreign interest rate
Let et and Ft be the spot and forward rate at t

Suppose we want to invest in foreign currency

We face currency risk when we repatriate earning
But we can hedge the risk by purchasing euros
forward today at Ft
One dollar invested in euros yields
euros
3 months from now I have
euros
So 3 months hence I have

dollars

Covered Interest Parity

Arbitrage requires that
Which is called CIPC
This implies

or

Ft et
i i*

et
1 i*

If not equal there are arbitrage profits to be made

Thus, a positive interest differential implies a
forward premium
Interest must compensate for capital loss

Covered Interest Arbitrage

Interest Parity Line

0.04
D
A

Ft et
et

C
B
-0.04
-0.04

i i*
1 i*

0.04

Adding Transactions Costs

0.04

PU
Ft et
et

C
B
-0.04
-0.04

i i*
1 i*

0.04

Dont Try This

CIPC
Take logs of both sides of CIPC
or, for small i

Most studies show that CIPC holds

Notice that there is no currency risk
Forward price signals markets expectation

Riskless Arbitrage: Covered Interest

Parity
Arbitrage profit?
Considers the German deutschmark
(GER) relative to the British pound
(UK), 1970-1994.
Determine whether foreign exchange
traders could earn a profit through
establishing forward and spot contracts
The profit from this type of
arrangement is:

Covered Interest Parity

Uncovered Interest Parity

Suppose we do not hedge our
investment
Again we invest one dollar
Let
be the expected future spot rate
In 3 months we earn
Arbitrage requires
UIPC, thus

CIPC and UIPC compared

The two conditions differ only in one term

versus
CIPC involves no currency risk
UIPC bears currency risk
Holds only if agents are risk neutral
Risk averse agents may require a risk premium

Notice that if

then UIPC holds

This would be cool => markets reveal expectations

We can test for this

Efficient Markets
Example of Efficient Markets Hypothesis
Investors use available information efficiently
Does not mean they are ex post correct, only
that prices reflect all available current
information in an efficient manner
Unbiased errors
If I am efficient my error pattern looks like that of
Tiger Woods
Of course, the variance of my pattern is greater, but we
are both on target on average

Market Efficiency

Testing for UIPC

We have data on F but not on

Rational expectations implies that forecast
errors are unbiased
Then

should be an unbiased predictor of

et 1

That is, guesses are on average correct

UIPC implies that

Thus, if REH and UIPC holds, then
et 1 Ft
unbiased predictor of
=> market is efficient!!!

What does unbiased mean?et 1

should be an

Ft

If I have a lot of observations, then the average value of Ft

should differ from et+1 only by a random error
Hiawathas Last Arrow

Euro Six Months Forward

Testing UIPC
So if I estimate

et 1 Ft X t t

Xt
where
of, and

t
is any variable you can think
is a random error

I should find
That is, all the information valuable
et 1
for predicting
is incorporated in
Ft
the market
price,

Testing UIPC
Typically one actually regresses changes,
so
With null hypotheses
Notice this is a joint test
REH and UIPC
So rejection could mean either
Expectations are not rational
UIPC does not hold (perhaps agents are not risk neutral)

Visual inspection does not vindicate UIPC

Empirical Test of UIPC

Yen Spot and Forward

Actual change in spot rate and

forward discount

Tests of UICP
Most tests find forward premium puzzle
Not only is
1
negative

in the data, it is often

If UIPC held, the pound should, on average,

appreciate when it is at a forward premium,
i.e., f > 0
The negative point estimates of imply that the
pound actually tends to depreciate when it is at
a forward premium.
UK interest rates exceed US by 2.41% on
average, but sterling appreciates by 22.25%

Forward Premium Puzzle

If UICP fails there are two possibilities
Markets are not efficient
risk premium is missing

We are testing a joint hypothesis

If marginal agents are risk averse ignoring
this could explain the forward puzzle
If income is volatile perhaps risk premium
varies
Or it could be Central Bank Behavior

Central Banks
Central Banks move exchange rates in short
run
They could set policy based on observations of F
E.g., intervene when risk premium rises
Seems that when CBs intervene heavily the forward
discount increases

Forward discount is larger in floating rate

regimes
Forward discount larger at shorter horizons
Interesting because CBs can only move e over short
periods
Less risk at longer horizons

Estimated Beta at different horizons

Short Horizon Tests

Longer Horizons

Risk Premium
But time varying risk premia hard to observe
To explain

risk premium must be more volatile than

Why would this be the case (assertion, see notes for explanation)?

We dont seem to be able to find such a risk premium

Why is forward discount larger for industrialized

economies?
Unlike major currencies, which generally show a coefficient
significantly less than zero, suggesting that the forward rate
actually points in the wrong direction, the coefficient for
emerging market currencies is on average slightly above zero,
and even when negative is rarely significantly less than zero.
Hard to reconcile with risk premium explanation
Emerging markets appear riskier but have a smaller risk
premium????

DXY Index

Can we make money?

If UIPC fails, can we make money?
One can pursue carry trade: borrow low
invest high
Let y be the amount of money borrowed, then

With payoff

So if

my profit would be

Carry Trade
Suppose we did this via dollar-yen
September 1993 till August 2003

Bet once a month for ten years, we have 120 observations

We would earn money, average profits positive = .0041
Profits are volatile
Sharpe ratio = 0.12 < than for S&P 500

.6 to
Carry trade is a bet against arbitrage,
on1.1lower
volatility

Sometimes carry trade leads to big losses, unexpected

currency movements
Like selling puts out of the money

Why dont investors arbitragers bet against it?

Incentive problem for fund managers
Rational inattention

Example

Example
Example: Japanese yen and Australian dollar
2001: steady increase in profits from carry trades.
Despite several months of positive carry profits, the
yen did not sufficiently appreciate against the
Australian dollar to offset these profits.

Leverage and margin

Example: You have $2,000 and borrow an additional
$48,000 in yen from a bank in Japan.
You have borrowed 25 times your own $2,000 capital, a leverage
ratio of 25. You conduct carry trade, investing $50,000 in the
Australian dollar.
If you lose 4% on the trade, youve lost your initial capital
investment. This initial capital put up by the investor of 4% of the
total investment is known as a margin.

Summary
Obviously if large institutions do this
losses could be huge. Duh!
Even if expected returns from arbitrage
are equal to zero, actual profits are
often not equal to zero.
Returns (profits/losses) are persistent.
Returns are volatile/risky.

US Dollar/Yen Exchange Rate

Price Pressure
Bid-ask spreads reduce size of profits
Large amounts of speculation needed to earn money
Speculator who be one pound on an equally-weighted portfolio
of carry-trade strategies (across the USA, Canada, Belgium,
France, Germany, Japan, Netherlands, Switzerland and the
euro) from 1976 to 2005 would earn an monthly payoff of
0.0025 pounds.
To earn an average annual payoff of 1 million pounds would
require a bet of 33.33 million pounds per month.
Is there an effect of such large trades?
Would they survive such speculation?
Prices rise with order flow
Could eat profits
You could break up trades, but this chews up profits as well
The marginal expected payoff can be zero, even when the
average payoff is positive
Speculators make profits but no money is left on the table

Risk versus Reward

Idea: Examine traders strategies and other
finance theories to study tradeoff between
risk and return.
Data: Positive 1% interest differential is
associated with only a 0.23% appreciation in the
currency, implying a 0.77% profit.
Problem: despite the existence of profits:
Profits do not rise/fall linearly, line is a poor fit for the
data. At higher differentials, variance in return higher.
Variance around the line is high in general, creating
uncertainty for investors.

Test of Efficient Markets

Not the high variance
of observations
around the line of
best fit
Observations do not
cluster around the
line of best fit
For the same interest
differential there are
vastly different actual
rates of depreciation
observed

Limits of Arbitrage
Returns positive for
currencies
Very high volatility of
returns
Sharpe ratios < 1
Equal to 0.5 0.6 for
market portfolio of
currencies
Differs little from stock
market

Puzzle like the equity

premium puzzle

Predictability and Nonlinearity

Linear model may be the problem
Nonlinear models reveal that low interest
differentials are associated with very low
profits.
At high differentials, investors engage in carry
trades, bidding up the currency, sometimes causing
reversals (and losses).
At the extreme ends, arbitrage appears to work, so
what is happening for moderate interest
differentials?
Investors are willing to take on some risk, if the return is
large enough.

Peso Problems

Could be due to peso problem

Samples used in tests are not long enough to have
big losses
Suppose you studied the dollar-baht rate for UIPC, 19901997
You miss a big depreciation in July 1997 but investors may
have considered it a possibility

Suppose e = 20c, and investors are 95% sure it will

stay
With prob = .05 they believe it will fall to 10c. Then,
So each period for which there is no change the forecast
error is positive:
Casual observer might assume irrationality

Example
Suppose peso is pegged to dollar
Let iUS .05
Then UIPC implies

Market predicts depreciation; each period the peg

holds UIPC is violated

But does not mean market is inefficient

Agents are calculating the small risk of a big depreciation
When the market corrects, losses are large
Argentina, Hong Kong

Hong Kong Peso Problem

Argentina Peso Problem

Thailand / U.S. Foreign Exchange Rate

Realized Profits on Yen Carry Trade

Realized Profits on Yen Carry Trade

Yen Positions of non-commercial traders at

the Merc

UIPC Regressions, in Sterling

Volatility Puzzle

Implied Yen Volatility (3 month)

Implied Yen Volatility (3 mo)

New Zealand 3 month T Bill

Yen/NZD Spot Rate and the Interest

Differential

Real Interest Parity

We have been looking at nominal
returns, what about real returns?
Fisher effect tells us that
So
If PPP holds, then

so

But PPP is too restrictive an assumption

What happens in general?

Real Interest Parity

We need to consider expected changes
in Q
So,
If inflation and exchange rates change at
the same rate there is no change in Q
UICP implies
so

RIPC
So, using the Fisher equation we obtain:
This implies that real interest differentials are equal
to expected changes in Q
Suppose people expect e
Q 0
Implies real value of the dollar will decline
Investors will demand a premium to hold US assets

Does this mean there are profits that are not

arbitraged?
No
Differences in real returns are not on the same asset
They are returns on different bundles of goods

RIPC Interpreted
Real interest differentials reflect nominal rates ' s
deflated by
over different consumption baskets
If agents were identical => PPP, so differences equalized
Because people in different countries consume different
baskets of goods, there is no way for them to arbitrage
away any difference.

Implies that we cannot look at real interest

differentials to study whether capital markets are
integrated
Qe
0
Capital markets can be
perfect,
but if large US
CA deficits lead to expectations of
then
real returns on US assets would have to exceed
those in the rest of the world

Exchange Rate Regimes

Two polar cases and many in the
middle
Fixed exchange rates
CB buys or sells reserves to maintain a set
price of foreign exchange

Flexible exchange rates

CB does not intervene in market for foreign
exchange

To understand, suppose demand and

supply of foreign exchange given by

Historical View on Exchange Rate

Regimes

Fixed versus Flexible

Shouldnt e be determined by market
forces?
Mundell versus Friedman
Foreign exchange is not like a normal market
Exchange rate is like a dictionary

Exchange of national currencies, fiat monies

A high price of foreign exchange does not lead to
more supply
No fundamentals driving the market
Government policy must control supply of money

Then why should they be flexible?

Friedman on Flexible Rates

If internal prices were as flexible as exchange rates, it

would make little economic difference whether
adjustments were brought about by changes in exchange
rates or by equivalent changes in internal prices.
The argument for flexible exchange rates is, strange to
say, very nearly identical with the argument for daylight
savings time. Isnt it absurd to change the clock in
summer when exactly the same result could be achieved
by having each individual change his habits? All that is
required is that everyone decide to come to his office an
hour earlier, have lunch an hour earlier, etc. But
obviously it is much simpler to change the clock that
guides all than to have each individual separately change
his pattern of reaction to the clock, even though all want
to do so. The situation is exactly the same in the
exchange market. It is far simpler to allow one price to
change, namely, the price of foreign exchange, than to
rely upon changes in the multitude of prices that
together constitute the internal price structure.

Foreign Exchange
If CB does not intervene, then market price
of foreign exchange is
Suppose demand for foreign exchange
increases
Then if CB does nothing, e must rise
To keep e fixed CB must sell foreign exchange
So international reserves fall

Thus,
where
is the fixed exchange rate
Notice that exchange rate can also be affected by
policy
By affecting demand or supply

Fixed Rates and Reserve

Accumulation
If the exchange rate is fixed, then
reserves adjust as demand and supply
shifts
The peg is sustainable if these shocks offset
Peg is unsustainable if shocks are biased
But there is asymmetry
Easier to accumulate foreign exchange
You cannot print it if you are running out!

When does a fixed rate collapse?

When reserves run out? No.

Time to Collapse
Suppose that the peg is unsustainable
When reserves run out the rate must
e%
collapse to

Implies that e will jump at that date, t

Implies capital gain at date t 1
So people will sell at t -1, implies capital gain, so
e collapses at t 1
Implies e collapses at t 2,

So e must collapse at earliest date at which

there is no capital gain
So e collapses before all reserves are depleted
Why not sell before tc ?
Because then they incur capital loss

Collapse
Exchange rate collapses before reserves run out
Nobody wants to be the last person to exit
If agents are forward looking they anticipate capital
losses
So currency cannot collapse and then jump to shadow rate

In practice we see that currency collapses before

reserves run out
Key is when CB is no longer willing to pay the cost of
maintaining the exchange rate
CB could always repurchase the MB
Problem is the cost of doing so
No longer lender of last resort, interest rates may skyrocket
External versus internal balance

Foreign Exchange Reserves and MB,

Sept 1994
(pct of GDP)

Fixing the Exchange Rate

Under fixed rates IR is changing to offset
any excess demand for foreign exchange
When there is ED > 0 the CB sells reserves,
so
If ED < 0, the opposite takes place

What is the effect of this operation?

Suppose no sterilization
That is no attempt to offset the operation of
pegging the exchange rate on the domestic
money supply

No Sterilization
Start with the CBs balance sheet

The assets of the CB, IR + DS = MB

The money supply just depends on the MB, so
Thus when reserves fall the money supply
contracts, and vice versa
Fixing the exchange rate means giving up control
over the supply of money

Example
Central bank balance sheet
condition:
Example:
Suppose the government purchases 500
million in domestic bonds and 500 million in
foreign assets (reserves).
Money supply is therefore equal to 1000
million pesos.

Central Bank Actions

Suppose the Fed purchases foreign exchange

4 cases
1. purchase from home-country banks:

in this case alongside the increase in IR is an increase in

bank reserves.

2. purchase from home-country non-bank residents:

in this case, residents would receive payment in the form of

currency in circulation.

3. purchase from home-country non-bank residents:

in this case, residents would receive payment in the form of

currency in circulation.

4. purchase from foreign banks or central banks via

changes in the foreign banks deposit at the Fed.

In this case, once the bank uses this deposit to purchase

some interest-bearing security from a domestic bank, bank
reserves will rise.

In all cases, the reserve transaction results in a

simultaneous change in MB

Sterilization
Sterilization occurs when the CB moves to
insulate the domestic economy from foreign
reserve transactions
Typically an open market operation: if inflows of foreign
exchange are swelling the money supply then the CB
sells bonds to soak it up, e.g.,
Notice that to persist in sterilization requires large
stocks of both foreign reserves and domestic securities.
obviously difficult for debtor, what about for surplus
case?
Need to keep selling DS, but how much will the public
buy?
Depends on how financially developed the economy
Interest cost of sterilization can be large

Effect on Monetary Policy

i

IR
P

i0

i1

L(Y, i)

M/ P

Impossible Trinity
We see that a country cannot simultaneously have:
Independent monetary policy
Fixed exchange rate
Capital mobility

With fixed e you interest rates cannot diverge from

i*
Conflict between internal and external balance
Chinas advantage
China does not have open capital account
So it can sterilize current account surpluses
Lack of capital mobility depresses local interest rates,
reduces costs of sterilization

Effect of large sterilization in some countries

could be future inflation

Carrying Costs (pct of GDP)

Foreign Reserves net of currency

Valuation Changes on Foreign

Reserves

China Balance of Payments

Transactions

Capital Account Components

Annual Changes in NFA, NDA, and

Reserves

Time of Collapse

Reserve Flow

Sustainable exchange rate

Unsustainable Exchange Rate

Mexicos External Balances

Ruble Exchange Rate

Monetary Base and Gross Reserves

Russian Foreign Exchange Reserves

(billions of $)
MB = $6.7 billion in Sept 1998

Market for Foreign Exchange

Varieties of Exchange Rate Regimes