6 International Parity Relationships and Forecasting Exchange Rates

Three main difficulties of the fundamental approach

- First, one has to forecast a set of independent variables to forecast the exchange rates. - Second, the parameter values, that is, α and β's, that are estimated using historical data may change over time because of changes in government policies and/or the underlying structure of the economy - Third, the model itself can be wrong.

PPP may not hold in reality but can still be useful in economic analysis

- benchmark in deciding if a country's currency is undervalued or overvalued against other currencies. - make more meaningful international comparisons of economic data using PPP-determined rather than market-determined exchange rates.

currency carry trade

- involves buying a high-yielding currency and funding it with a low-yielding currency, without any hedging - often doesn't hold, giving rise to uncovered interest arbitrage opportunities

Important factor in spot exchange rate determination

- relative interest rates - forward exchange rate - expectation : when people "expect" the exchange rate to go up in the future, it goes up now. - News events : dynamic and volatile short-term behavior as a result

There are three distinct approaches to exchange rate forecasting:

-(a) the efficient market approach, -(b) the fundamental approach, and -(c) the technical approach

IRP implies that in the short run, the exchange rate depends on

-(a) the relative interest rates between two countries, and -(b) the expected future exchange rate -a higher (lower) domestic interest rate will lead to appreciation (depreciation) of the domestic currency.

Setting Dealer Forward Bid and Ask

-Dealer buys foreign currency at the bid price. -Dealer sells foreign currency at the ask price. -Dealer borrows (from customer) at the lending rates. -Dealer lends to his customer at the posted borrowing rates

The efficient market hypothesis (EMH)

Financial markets are said to be efficient if the current asset prices fully reflect all the available and relevant information

PPP

PPP probably doesn't hold precisely in the real world for a variety of reasons. •PPP-determined exchange rates still provide a valuable benchmark.

Technical Approach

The technical approach first analyzes the past behavior of exchange rates for the purpose of identifying "patterns" and then projects them into the future to generate forecasts - premise that history repeats itself

Competitiveness of the domestic country

q = 1: Competitiveness of the domestic country unaltered. q < 1: Competitiveness of the domestic country improves. q > 1: Competitiveness of the domestic country deteriorates

Forecasting Exchange Rates: Efficient Markets Approach

•Financial markets are efficient if prices reflect all available and relevant information. - affordable and is hard to beat.

theory of purchasing power parity (PPP)

When the law of one price is applied internationally to a standard consumption basket - exchange rate between currencies of two countries should be equal to the ratio of the countries' price levels

if there are deviations from PPP, changes in nominal exchange rates cause changes in the______ affecting the international competitive positions of countries. This, in turn, would affect countries' trade balances

real exchange rates

Fisher effect

an increase (decrease) in the expected inflation rate in a country will cause a proportionate increase (decrease) in the interest rate in the country. - implies that the expected inflation rate is the difference between the nominal and real interest rates in each country

The Exact Fisher Effects

•An increase (decrease) in the expected rate of inflation will cause a proportionate increase (decrease) in the interest rate in the country.

If IRP is violated

one can lock in guaranteed profit by borrowing in one currency and lending in another, with exchange risk hedged via forward contract. -As a result of this covered interest arbitrage, IRP will be restored

Deviations from IRP do not represent unexploited profit opportunities; rather, they reflect the ________.

existence of significant barriers to cross-border arbitrage

All else equal, an increase in the U.S. interest rate will lead to a ________ foreign exchange value of the dollar

higher

capital controls

imposed by governments. - For various macroeconomic reasons, governments sometimes restrict capital flows, inbound and/or outbound. - achieve this by means jawboning, imposing taxes, or even outright bans on cross-border capital movements

Random Walk Hypothesis

suggests that today's exchange rate is the best predictor of tomorrow's exchange rate

arbitrage

the act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making certain, guaranteed profits

Uncovered Interest Rate Parity

the interest rate differential between a pair of countries is (approximately) equal to the expected rate of change in the exchange rate

Interest rate parity (IRP) holds that the forward premium or discount should be equal to -

the interest rate differential between two countries.

IRP is a manifestation of the

the law of one price (LOP)

international Fisher effect (IFE)

the nominal interest rate differential reflects the expected change in exchange rate

Purchasing power parity (PPP) states that the exchange rate between two countries' currencies should be equal to

the ratio of their price levels

When IRP doesn't hold, the situation also gives rise to

to covered interest arbitrage opportunities

Reasons for Deviations from Interest Rate Parity

transaction costs and capital controls

Since the advent of the flexible exchange rate system in 1973, exchange rates have become increasingly more ________

volatile and erratic

forward expectations parity (FEP)

when the international Fisher effect is combined with IRP - FEP states that any forward premium or discount is equal to the expected change in the exchange rate

If IRP holds strictly, deviations from it would be randomly distributed, with the expected value of _____.

zero

Interest Rate Parity Defined

•IRP is a "noarbitrage" condition. •If IRP did not hold, then it would be possible for an astute trader to make unlimited amounts of money exploiting the arbitrage opportunity. •IRP holds most of the time

Forecasting Exchange Rates: Fundamental Approach

•Involves econometrics to develop models that use a variety of explanatory variables. This involves three steps: -Step 1: Estimate the structural model. -Step 2: Estimate future parameter values. -Step 3: Use the model to develop forecasts. •The downside is that fundamental models do not work any better than the forward rate model or the random walk model.

Forecasting Exchange Rates: Technical Approach

•Technical analysis looks for patterns in the past behavior of exchange rates. •It is based upon the premise that history repeats itself.

Reasons for Deviations from IRP

•Transactions Costs-The interest rate available to an arbitrageur for borrowing, may exceed the rate he can lend at •Capital Controls - Governments restrict import/export of money through taxes or outright bans.

Currency Carry Trade

•involves buying a currency that has a high rate of interest and funding the purchase by borrowing in a currency with low rates of interest, without any hedging. •profitable as long as the interest rate differential is greater than the appreciation of the funding currency against the investment currency.