Chapter 4 Bus187
Calculating Interest Rate Parity
(1 + iUS) = (F/S)(1 + iE) where iUS= interest rate on U.S. bond paid in euros iE=interest rate on European bond paid in euros F=forward dollar to euro exchange rate S=spot dollar to euro exchange rate. This equation says that a dollar invested in a U.S. bond earns the same dollar return as a dollar converted to euros and invested in European bonds with euro returns later repatriated to dollars. If S is fairly stable over time, this IRP can be approximated with the following well-known formula:(iUS - iE) = (F - S)/S = p
What's in Your Wallet?
1. Dollarization 2.Hard currencies 3.Soft currencies
Setting Exchange Rates
1. Independent floating exchange rate system 2. Managed floating exchange rate system 3. Fixed exchange rate system
International Flows of Goods and Capital
1. Law of one price 2.Arbitrage 3.Purchasing power parity (PPP)
International Monetary Systems
1. Money and Inflation 2. Gold standard 3. Bretton Woods Agreement 4. International Monetary Fund (IMF)
Current account consists four subaccounts(the sum of four subaccounts)
1. Trade balance is the net of merchandise exports (+) and merchandise imports (-). When export>import - surplus, import>export - deficit. TOP TEN COUNTRIES TRADING WITH THE UNITED STATES - Canada, China, Mexico 2. Services balance is the net of exports of services and imports services. United States is primarily a service economy 3. Income balance is net of investment income from abroad and investment payments to foreigners 4. Balance of transfers is the net of transfers payments going overseas and inflows from abroad
Problems with PPP
1.Empirical tests of PPP have found mixed results:-PPP appears to hold in the long run for periods exceeding five years, but may not hold in shorter periods.-For countries with little difference in inflation rates, PPP does not reliably explain exchange rate changes. 2.PPP predictions are affected by:-Transportation costs and trade barriers-Government intervention in trade and exchange rates-Multinational firms with pricing power-Market expectations about economic factors-Goods not traded but that affect internal prices
The Financial Account of the BOP
1.Risk premium 2.Foreign direct investment (FDI) 3.Statistical discrepancy
Development of the Flexible Exchange Rate System
1.Smithsonian Agreement -The 1971 decision allowing the United States to devalue the dollar against other countries' currencies 2.Jamaica Agreement -The 1976 international monetary order that allowed countries to adopt different exchange rate systems including floating their currencies in world markets
Valuing (or Devaluing) Currencies
1.Special drawing right (SDR) 2.Clean float currency 3.Dirty float currency
Components of the Foreign Exchange Market (forex market)
1.Spot market 2.Forward market 3.Futures market
Special drawing right (SDR)
A basket of currencies (dollars, euros, pounds, and yen) created by the IMF for use as a benchmark to value the currencies of different countries
Arbitrage
Buying goods in a lower priced market and selling them in a higher priced market to make profits
Financial account
Consists of domestic-country-owned assets abroad, foreign-owned assets in the domestic country, and net financial derivatives
Soft currencies
Emerging market countries' currencies that are less stable in value than hard currencies and are sometimes pegged to hard currency values
What the difference between spot and exchange rates?
Expectations by investors about future exchange rate movements
Interest Rate Parity
Interest rate parity (IRP) Covered interest rate parity Uncovered interest rate parity
Hard currencies
Leading world currencies of developed industrialized countries, including the dollar, euro, yen, and pound
Gold standard
Monetary system that pegs currency values to the market value of gold
Clean float currency
Monetary system with minimal government intervention; largely market determined
Dirty float currency
Monetary system with varying degrees of government intervention to maintain a range of acceptable values against other currencies
Inflation and Purchasing Power Parity
PUS(1 + IUS) = (1 + p)PE(1 + IE), wherePUS=price index of U.S. goods in dollarsPE=price index of European goods in dollarsIUS=inflation rate in the United States in dollar termsIE=inflation rate in Europe in euro termsp=percentage change in the euro, which equals the forward premium [(F - S)/S] 100 with F the forward dollar/euro exchange rate and S the spot dollar/euro exchange rate. Given an exchange rate of $1.40 per euro, an initial PPP with PUS = $140 and PE = €100 or $140, and 10 percent U.S. inflation and 0 percent European inflation, we have$140(1.10) = (1+ p) $140(1),such that the forward premium p = [($154 - $140)/$140] 100 = 10 percent.
Uncovered interest rate parity
Principle implying that expected forward exchange rates and spot exchange rates set interest rates on bonds in different countries equal to one another
Covered interest rate parity
Principle implying that forward exchange rates and spot exchange rates set interest rates on bonds in different countries equal to one another
Law of one price
Principle stating that identical goods should sell for the same price in different countries according to local currencies
Statistical discrepancy
Reconciles imbalances between the current account and financial account to ensure that debit and credit entries in the BOP statement sum to zero
Balance of payments (BOP)
Shows all transactions between one country and the rest of the world for a given period of time
Current account
Shows the activities of consumers and businesses in the economy with respect to the trade balance, services balance, income balance, and net transfers
Bretton Woods Agreement
The 1944 decision to establish a global currency system with the U.S. dollar pegged at a fixed rate of exchange to gold, and the currencies of 43 other countries fixed to the dollar
Do You Want PPP Fries with That?The Big Mac Index
The Big Mac Index-A calculation using the cost of a Big Mac sandwich to assess the relative values of currencies-Click on the following link to view the Big Mac index cited in the textbook and its associated chart:Big Mac Index-
Risk premium
The added return required by investors for risk associated with a security or asset
International Monetary Fund (IMF)
The financial authority established under the Bretton Woods Agreement to help ensure the stability of the international monetary and financial system
Dollarization
The practice of using the dollar or some other foreign currency together with, or instead of, a domestic currency in a country
Foreign direct investment (FDI)
The purchases of fixed assets (such as factories and equipment) abroad used in the manufacture and sales of goods and services abroad
Purchasing power parity (PPP)
Theory stating that a basket of goods should have approximately the same prices across different countries
Interest rate parity (IRP)
Theory stating that the bond interest rate in different countries will become the same as investors buy and sell bonds to make arbitrage profits
Foreign Exchange Markets
a global network of international banks and currency traders that trade different countries' currencies
Inflation
an increase in the prices of goods and services caused by the supply of money exceeding the demand for goods and services
Two major components of BOP
current account and financial account
Financial account consists
domestic-country-owned assets abroad, foreign-owned assets abroad in the domestic country, and net financial derivatives
Forward market
exchange that enables purchases and sales of currencies in the future with prices (or the forward rate) established at a previous time. It is an informal over the counted (OTC) market run by banking institutions.
Spot market
exchange that trades currencies on a real-time basis for immediate delivery. For example, a British firm may need dollars to pay for US imports.
Discount
in the forward market, the selling of a currency at a spot rate that is less than the forward rate
Premium
in the forward market, the selling of a currency at a spot rate that is more than the forward rate
Hedge(lower risk)
insurance that reduces future risk
Direct quotes
prices of a foreign currency in dollars, or the number of dollars per one unit of foreign currency
Fixed exchange rate system
system in which the country pegs its currency at a fixed rate to a major currency or basket of currencies, while the exchange rate fluctuates within a narrow margin around a central rate
Managed floating exchange rate system
system that determines the value of some currencies partly by demand and supply in the foreign exchange market, and partly by active government intervention in the foreign exchange market
Independent floating exchange rate system
system that sets the values of major currencies based on their demand and supply in world currency markets. For example exchange rates between the US dollars, euro, and yen
Bid-ask spread
the difference between the bid and the ask prices of a currency; the transaction fee earned by the bank. the bid(buy) and ask(sell)
Exchange rate
the price at which one currency can be converted to another currency
Indirect quotes
the reciprocal of the direct quote, or the prices of a dollar (for example) in foreign currency terms
Problems with IRP
•Empirical evidence on IRP theories is mixed:-Transactions cost is one impediment to achieving IRP.-Political risk, legal restrictions, tax effects, managed-float rate regimes can disrupt traders' ability to arbitrage away profit differentials.-Market psychology (herd behavior) can play a role in rate movements as traders speculate in currencies.-Central bank intervention may cause IRP not to hold at all points in time.
Forecasting Exchange Rates
•Using the forward rate in the covered IRP to forecast future spot rates: F = S(1 + p), where F = forward rate, S = spot rate, and p = forward premium. •Using a multiple regression model: X = b0 + b1(IUS - IE) + b2(iUS- iE) + b3(YUS- YE), where(IUS - IE)=difference in inflation rates(iUS - iE)=difference in interest rates(YUS - YE)=difference in GDP growth rates.
