1、 6 The Foreign Exchange Rate Determinants (Chapter 6) McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-1 Essential Readings P139-140 P148-157 McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Value of Quantity of D: Dem
2、and for $1.55 $1.50 $1.60 S: Supply of equilibrium exchange rate Equilibrium Exchange Rate lAn exchange rate represents the price of a currency, which is determined by the demand for that currency relative to the supply for that currency. McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies
3、, Inc. All rights reserved. 5-3 Main Contents lPurchasing Power Parity lInterest Rate Parity lThe International Fisher Effects McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-4 Purchasing Power Parity lThe theory of purchasing power parity(PPP) is based on
4、the The law of one price. lThe law of one price states that one basket of goods should cost the same regardless of the currency in which it is sold. McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-5 Purchasing Power Parity lAbsolute Purchasing Power Parity
5、lRelative Purchasing Power Parity McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-6 Purchasing Power Parity lAbsolute Purchasing Power Parity states that the exchange rate between two currencies should equal the ratio of the countries price levels. S($/) =
6、P$ P lE.g. The standard basket of goods costs $225 in the US, and 150 in the UK, the exchange rate between $ and is: l S=$225/ 150=$1.5/ McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-7 Purchasing Power Parity lRelative Purchasing Power Parity states that
7、the rate of change in an exchange rate is equal to the differences in the rates of inflation. e = $ - Alternatively, suppose the base year price index is identical between two countries, the equilibrium exchange rate at t: St =S0 (Ph t /Pf t) lIf U.S. inflation is 5% and U.K. inflation is 8%, the po
8、und should depreciate by 3%. McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-8 Purchasing Power Parity lSuppose that the rate of sterling and USD at the beginning of the year is at USD1.50/ lOver the year the inflation rate in the UK is 15%, the same basket
9、 costs 11,500 at the end of the year. lUS prices rose by 3% and the US domestic cost of a basket will be USD15,450. McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-9 Purchasing Power Parity lIf the exchange rate remains at $1.50/ : lA UK consumer has two ch
10、oices: to buy 11,500 of UK produced goods or exchange 11,500 into dollars and buy US goods. l11,500 will buy $17,250 at $1.50/ , more than one basket. lAs the inflation rate difference is 15%-3%=12% $/ 1 =$/ 0 x(1-12%)=1.5x0.88=1.32 McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc.
11、 All rights reserved. 5-10 Purchasing Power Parity The US dollar appreciates against sterling by about 12%. A basket of goods costing USD 15,450 in the USA has a sterling cost of 15,450/1.32= 11,500and thus PPP maintained. McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All right
12、s reserved. 5-11 Test On PPP lIf big Mac represents all traded goods and services then the PPP should hold true if using PPP to test. The economists have used Big Mac to test. Overvalue and undervalue against dollars are found. McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All
13、rights reserved. 5-12 Test on PPP lThe Hamburger Standard Big Mac Prices implied PPP Actual rate Value difference USA $2.54 China RMB9.90 $3.90 8.28 -53% Britain GBP1.99 $1.28 1.43 12% Hong kong HK$10.70 $4.21 7.80 - 46% Canada C$3.33 $1.31 1.56 -16% McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hi
14、ll Companies, Inc. All rights reserved. 5-13 Does PPP hold True? lPPP holds better in the following circumstances: nLong run rather than short run nGeographically close countries nWhen the country has a very high inflation rate-PPP becomes dominant. nFor traded goods rather than non-traded goods( in
15、flation index based on traded goods only) McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-14 Does PPP hold true? lLong run-Yes. lShort run-rarely lWhy doesnt it work all the time? nIt only applies to goods freely traded internationally (there are non-traded
16、 goods, transportation fee, and trade barriers). nSpeculation nGovernments manage exchange rate. nMany other factors like FDI, portfolio investment. McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-15 Why is PPP still widely used？ lOne can use PPP determined
17、 exchange rate as a benchmark in judging whether a countrys currency is undervalued or overvalued. lOne can use PPP determined exchange rate in getting more meaningful international comparison of economic data. McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
18、5-16 Interest Rate Parity lIRP is a “no arbitrage” condition. lIf IRP did not hold, then it would be possible for an astute trader to make unlimited amounts of money by exploiting the arbitrage opportunity. lSince we dont typically observe persistent arbitrage conditions, we can safely assume that I
19、RP holds. Almost all the time! McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-17 Interest Rate Parity lThe IRP holds that the equilibrium exchange rate reaches when the expected return of two currencies are equal in terms of the same currency. McGraw-Hill/
20、Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-18 Interest Rate Parity lIRP holds that differences in nominal interest rates between currencies determine the premium or discount on currencies in the forward exchange rates. McGraw-Hill/Irwin Copyright 2001 by The McGra
21、w-Hill Companies, Inc. All rights reserved. 5-19 Interest Rate Parity lThe formula which links together the spot, forward and interest rate differences is: S (F- S) ) -i(i $ McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-20 Interest Rate Parity Defined Sup
22、pose you have $100,000 to invest for one year. You can either 1.invest in the U.S. at i$. Future value = $100,000(1 + iu s) 2.trade your dollars for yen at the spot rate, invest in Japan at i and hedge your exchange rate risk by selling the future value of the Japanese investment forward. The future
23、 value = $100,000(F/S)(1 + i) Since both of these investments have the same risk, they must have the same future valueotherwise an arbitrage would exist. (F/S)(1 + i) = (1 + ius) McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-21 Interest Rate Parity Define
24、d Formally, (F/S)(1 + i) = (1 + ius) or if you prefer, S F i i $ 1 1 IRP is sometimes approximated as S (F- S) ) -i(i $ McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-22 Interest Rate Parity Defined lIn other words, IRP holds when the differences between s
25、pot and forward exchange rate is equal to the differences in interest rates between the two countries whose forward rates are quoted, but in the opposite sign. McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-23 Interest Rate Parity lIf the following interes
26、t rates are assumed: lC$=15%, =10%, and spot rate is 1 =C$2.20, lWhat will the 12 month forward rate be? l 0.15-0.10=(F-2.20)/2.20 l Forward 1 =C$2.31 l McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-24 Interest Rate Parity lDoes the interest rate parity t
27、heory hold in practice? Generally yes. lIt has been empirically tested and proved by some research. McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-25 Reasons for Deviations from IRP lTransactions Costs nThe interest rate available to an arbitrageur for bor
28、rowing, ib,may exceed the rate he can lend at, il. nThere may be bid-ask spreads to overcome, Fb/Sa F/S nThus (Fb/Sa)(1 + il) (1 + i b) 0 lCapital Controls nGovernments sometimes restrict import and export of money through taxes or outright bans. McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill C
29、ompanies, Inc. All rights reserved. 5-26 The Fisher Effects lAn increase (decrease) in the expected rate of inflation will cause a proportionate increase (decrease) in the interest rate in the country. lFor the U.S., the Fisher effect is written as: i$ = $ + E($) Where $ is the “real” U.S. interest
30、rate E($) is the rate of U.S. inflation i$ is the nominal US interest rate. McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-27 The Fisher Effects lSuppose the expected real interest rate is 2% per year in the US. And the expected inflation rate is 4% per ye
31、ar, the nominal interest rate will be set as 6%. McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-28 International Fisher Effect If the Fisher effect holds in the U.S. i$ = $ + E($) and the Fisher effect holds in Japan, i = + E() and if the real rates are th
32、e same in each country $ = then we get the International Fisher Effect E(e) = i$ - i . McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-29 International Fisher Effect lIn conclusion, lInternational Fisher Effect means the spot rate of exchange should change
33、an amount equal to, but in the opposite direction of the difference in interest rates between the two countries. McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-30 International Fisher Effect If the International Fisher Effect holds, E(e) = i$ - i and if IR
34、P also holds S (F - S) E(e) S (F- S) -ii $ then forward parity holds. McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-31 Forward Parity lIn conclusion, forward rate is unbiased predicator of the future spot rate. McGraw-Hill/Irwin Copyright 2001 by The McGr
35、aw-Hill Companies, Inc. All rights reserved. 5-32 Forward Parity lIf the foreign exchange market quotes a 5% premium on a foreign currency, the future exchange spot rate for that maturity should appreciate by 5% between now and the maturity date. On the contrary, it indicates 5% depreciate. McGraw-H
36、ill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-33 Equilibrium Exchange Rate Relationships S (F - S) E(e) )-i(i $ $ - IRP PPP FEFRPPP IFEFP McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Government Controls lGovernments may
37、 influence the equilibrium exchange rate by: nimposing foreign exchange barriers, nimposing foreign trade barriers, nintervening in the foreign exchange market, and naffecting macro variables such as inflation, interest rates, and income levels. Factors that Influence Exchange Rates McGraw-Hill/Irwi
38、n Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-35 $/ Quantity of S0 D0 r0 U.S. income level U.S. demand for British goods, and hence . D1 r1 Other Factors that Influence Exchange Rates Relative Income Levels No expected change for the supply of . ,S1 McGraw-Hill/Irwin Cop
39、yright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Expectations lForeign exchange markets react to any news that may have a future effect. For example, news of potential increase in US inflation may cause traders to sell dollars, anticipating a future decline in the dollars value. T
40、his would places immediate downward pressure on the dollars. Other factors that Influence Exchange Rates: Expectation McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-37 Other factors that influence exchange rate: Expectation lBecause of speculative transact
41、ions, foreign exchange can be very volatile. McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-38 Interaction of Factors lTrade-related factors and financial factors sometimes interact. Exchange rate movements may be simultaneously affected by these factors.
42、lFor example, an increase in the level of income sometimes causes expectations of higher interest rates. Factors that Influence Exchange Rates McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-39 Interaction of Factors Factors that Influence Exchange Rates lT
43、he sensitivity of the exchange rate to these factors is dependent on the volume of international transactions between the two countries. lOver a particular period, different factors may place opposing pressures on the value of a foreign currency. McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill C
44、ompanies, Inc. All rights reserved. 5-40 Performance of the Forecasters lForecasting is difficult, especially with regard to the future. lAs a whole, forecasters cannot do a better job of forecasting future exchange rates than the forward rate. lThe founder of Forbes Magazine once said: “You can mak
45、e more money selling advice than following it.” McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-41 Exercises lWhile you were visiting London, you purchased a Jaguar for 35,000, payable in three months. You have enough cash at your bank in New York City, whi
46、ch pays 0.35% interest per month, compounding monthly, to pay for the car. Currently, the spot exchange rate is $1.45/ and the three-month forward exchange rate is $1.40/. In London, the money market interest rate is 2.0% for a three-month investment. There are two alternative ways of paying for you
47、r Jaguar. l(a) Keep the funds at your bank in the U.S. and buy 35,000 forward. l(b) Buy a certain pound amount spot today and invest the amount in the U.K. for three months so that the maturity value becomes equal to 35,000. lEvaluate each payment method. Which method would you prefer? Why? McGraw-H
48、ill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-42 Exercises lCurrently, the spot exchange rate is $1.50/ and the three- month forward exchange rate is $1.52/. The three-month interest rate is 8.0% per annum in the U.S. and 5.8% per annum in the U.K. Assume that yo
49、u can borrow as much as $1,500,000 or 1,000,000. la. Determine whether the interest rate parity is currently holding. lb. If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps and determine the arbitrage profit. lc. Explain how the IRP will be restored as
50、a result of covered arbitrage activities. McGraw-Hill/Irwin Copyright 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-43 lWhile you are visiting London, you purchased a Jaguar for 35,000, payable in three months. You have enough cash at your bank in New York City, which pays 0.35% per
