lecture 2 - 4

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LECTURES 2 - 4

The Foreign Exchange Market

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• Exchange rates affect large flows of international

trade ! infl"encing the #rices in different c"rrencies$• Foreign exchange also facilitates %assi&e flows ofinternational in&est%ent' which incl"de directin&est%ents as well as stock and ond trades$

• (n the foreign exchange %arket' trillions of dollarsare traded each da! and the econo%ic i%#licationsof shifts in the %arket can e dra%atic$

(ntrod"ction

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)e egin to st"d! the nat"re and i%#act of acti&it! in

the foreign exchange %arket$ The to#ics we co&erincl"de*•exchange rate asics• asic facts a o"t exchange rate eha&ior

•the foreign exchange %arket•two ke! %arket %echanis%s* arbitrage andexpectations

(ntrod"ction

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Exchange Rate* +asics• ,n exchange rate E . is the #rice of so%e foreign

c"rrenc! ex#ressed in ter%s of a ho%e or do%estic.c"rrenc!$• +eca"se an exchange rate is the relati&e #rice of two

c"rrencies' it %a! e /"oted in either of two wa!s*

0$ The n"% er of ho%e c"rrenc! "nits that can eexchanged for one "nit of foreign c"rrenc!$2$ The n"% er of foreign c"rrenc! "nits that can e

exchanged for one "nit of ho%e c"rrenc!$

• 1nowing the for%at in which exchange rates are /"otedis essential to a&oid conf"sion' so we now esta lish as!ste%atic r"le' e&en if it is ar itrar!$

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• To a&oid conf"sion' we %"st s#ecif! whichco"ntr! is the ho%e co"ntr! and which is foreign$

• Thro"gho"t this co"rse' when we refer to a

#artic"lar co"ntr! s exchange rate' we will /"oteit in ter%s of "nits of ho%e c"rrenc! #er "nits offoreign c"rrenc!$

• For exa%#le' 3en%ark s exchange rate with theE"ro one is /"oted as 3anish krone #er e"ro orkr56.$

3efining the Exchange Rate

+asics

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Exchange Rate 7"otations This ta le shows %a8or exchange rates as the! %ight a##ear in

the financial %edia$ Col"%ns 0. to 9. show rates on :"ne 9;' 2;0;$ For co%#arison'col"%ns 4. to

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• (f one c"rrenc! "!s %ore of another c"rrenc!'we sa! it has ex#erienced an a##reciation B its&al"e has risen ' appreciated or strengthened $

• (f a c"rrenc! "!s less of another c"rrenc!' wesa! it has ex#erienced a de#reciation B its&al"e has fallen ' depreciated ' or weakened.

,##reciations and 3e#reciations

+asics

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Si%ilarl!' in E"ro#ean ter%s' the following holdstr"e*

)hen the E"ro one exchange rate E 65? rises, the

#rice of one dollar goes "# in e"ro ter%s and thee"ro ex#eriences a de#reciation$)hen the E"ro one exchange rate E 65? falls, the

#rice of one dollar goes down in e"ro ter%s andthe e"ro ex#eriences an a##reciation$


+asics

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To deter%ine the si e of an a##reciation or de#reciation' we co%#"tethe #ro#ortional change' as follows*


+asics

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To aggregate different trends in bilateral exchange ratesinto one %eas"re' econo%ists calc"late multilateral exchange rate changes for askets of c"rrencies "singtrade weights to constr"ct an a&erage of all the ilateralchanges for each c"rrenc! in the asket$

The res"lting %eas"re is called the change in the effecti&eexchange rate$

M"ltilateral Exchange Rates

+asics

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For exa%#le' s"##ose 4; of Do%e trade is with co"ntr!0 and

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(n general' s"##ose there are N c"rrencies in the asket'and Do%e s trade with the N #artners is Trade @ Trade 0 Trade 2 $ $ $ TradeN $

,##l!ing trade weights to each ilateral exchange rate

change' the ho%e co"ntr! s effecti&e exchange rateE effecti&e. will change according to the following weighteda&erage*


+asics

changesrateexchangenominal bilateralof averageweighted-Trade

2

2

21

1

1

effective

effective

Trade

Trade

Trade

Trade

Trade

Trade N

N

N

E

E

E

E

E

E

E

E ∆++

∆+

∆=

∆

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+asics

Effecti&e Exchange Rates*Change in the Gal"e of the U$S$3ollar' 2;;2B2;0; The chartshows the &al"e of the dollar%eas"red ! the U$S$ FederalReser&e "sing two different

askets of foreign c"rrencies'starting with the index set to 0;;in :an"ar! 2;;2$

,gainst a asket of H %a8orc"rrencies' the dollar hadde#reciated ! %ore than 2A !

late 2;;4' and 9A ! earl! 2;;>$

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Exa%#le* Using Exchange Rates to Co%#are Iricesin a Co%%on C"rrenc!

+asics

Using the Exchange Rate to Co%#are Irices in a Co%%on C"rrenc! This ta le showshow the h!#othetical cost of :a%es +ond s next t"xedo in different locations de#ends onthe exchange rates that #re&ail$

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Exa%#le* Using Exchange Rates to Co%#are Iricesin a Co%%on C"rrenc!

+asics

Changes in the exchange rate ca"se changes in #ricesof foreign goods ex#ressed in the ho%e c"rrenc!$Changes in the exchange rate ca"se changes in therelati&e #rices of goods #rod"ced in the ho%e andforeign co"ntries$)hen the ho%e co"ntr! s exchange rate de#reciates'ho%e ex#orts eco%e less ex#ensi&e as i%#orts toforeigners' and foreign ex#orts eco%e %ore ex#ensi&eas i%#orts to ho%e residents$)hen the ho%e co"ntr! s exchange rate a##reciates'ho%e ex#ort goods eco%e %ore ex#ensi&e as i%#ortsto foreigners' and foreign ex#ort goods eco%e less

ex#ensi&e as i%#orts to ho%e residents$

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Exchange Rates in Iractice

Econo%ists gro"# different #atterns ofexchange rate eha&ior into categoriesknown as exchange rate regi%es$

There are two %a8or regi%e t!#es Bfixed and flexi le$

Exchange Rate Regi%es* Fixed Gers"s Floating

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Exchange Rates in IracticeExchange Rate Regi%es* Fixed Gers"s Floating

J Fixed or #egged. exchange rate regi%es are those inwhich a co"ntr! s exchange rate fl"ct"ates in a narrow rangeor not at all. against so%e base currency o&er a s"stained

#eriod' "s"all! a !ear or longer$ , co"ntr! s exchange ratecan re%ain rigidl! fixed for long #eriods onl! if thego&ern%ent inter&enes in the foreign exchange %arket in oneor oth co"ntries$J Floating or flexi le. exchange rate regi%es are those inwhich a co"ntr! s exchange rate fl"ct"ates in a wider range'and the go&ern%ent %akes no atte%#t to fix it against an!

ase c"rrenc!$ ,##reciations and de#reciations %a! occ"rfro% !ear to !ear' each %onth' ! the da!' or e&er! %in"te$

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,IIL(C,T(KRecent Exchange Rate Ex#eriences

E&idence fro% 3e&elo#ed Co"ntries• ,s shown in fig"re 0;-2' the U$S$ dollar is in a floatingrelationshi# with the !en' the #o"nd' and the Canadiandollar or loonie .$

•The U$S$ dollar is s" 8ect to a great deal of &olatilit!eca"se it is in a floating regi%e' or free float$•The 3anish krone #ro&ides a contrast an exa%#le of afixed exchange rate in a de&elo#ed co"ntr!$ There isonl! a tin! &ariation aro"nd this rate' no %ore than #l"sor %in"s 2 $ This t!#e of fixed regi%e is known as a

and$

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,IIL(C,T(K

Exchange Rate +eha&ior* Selected 3e&elo#ed Co"ntries' 0==

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Exchange Rate +eha&ior* Selected 3e&elo#ed Co"ntries' 0==

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,IIL(C,T(K

E&idence fro% 3e&elo#ing Co"ntries Exchange rates inde&elo#ing co"ntries can e %"ch %ore &olatile thanthose in de&elo#ed co"ntries$•(ndia is an exa%#le of a %iddle gro"nd' so%ewhere

etween a fixed rate and a free float' called a %anagedfloat also known as dirt! float' or a #olic! of li%itedflexi ilit!$•3ra%atic de#reciations' s"ch as those of Thailand andSo"th 1orea in 0==H' are called exchange rate crisesand the! are %ore co%%on in de&elo#ing co"ntries thanin de&elo#ed co"ntries$

Recent Exchange Rate Ex#eriences

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,IIL(C,T(K

Selected 3e&elo#ing Co"ntries' 0==

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,IIL(C,T(K

E&idence fro% 3e&elo#ing Co"ntriesExchange rates in Latin ,%erican co"ntries are e&en%ore &olatile$•Colo% ia #resents an exa%#le of a different kind of

fixed exchange rate$ Dere the a"thorities did not targetthe le&el of the Colo% ian #eso "t allowed it to steadil!de#reciate at an al%ost constant rate for se&eral !earsfro% 0==< to 2;;2$•This t!#e of fixed arrange%ent is called a crawl if theexchange rate follows a si%#le trend' it is a crawling

peg N if so%e &ariation a o"t the trend is allowed' it ister%ed a crawling band .$


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,IIL(C,T(K

Selected 3e&elo#ing Co"ntries' 0==

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,IIL(C,T(K

C"rrenc! Unions and 3ollari ationUnder a c"rrenc! "nion or %onetar! "nion.' there isso%e for% of transnational str"ct"re s"ch as a singlecentral ank or %onetar! a"thorit! that is acco"nta le tothe %e% er nations$ The %ost #ro%inent exa%#le of ac"rrenc! "nion is the E"ro one$Under dollari ation one co"ntr! "nilaterall! ado#ts thec"rrenc! of another co"ntr!$ The reasons for this choicecan &ar!$ , s%all si e' #oor record of %anaging%onetar! affairs' or if #eo#le si%#l! sto# "sing thenational c"rrenc! and switch en %asse to an alternati&e$


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,IIL(C,T(K

, S#ectr"% of Exchange Rate Regi%es The chart shows a recent classification ! the(nternational Monetar! F"nd (MF. of exchange rate regi%es aro"nd the world$

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,IIL(C,T(K

, S#ectr"% of Exchange Rate Regi%es contin"ed. The chart shows a recent classificationof exchange rate regi%es aro"nd the world$

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Foreign Exchange Market• The forex %arket is not an organi ed exchange* trade is

cond"cted Po&er the co"nter$Q• The forex %arket is %assi&e and has grown dra%aticall!

in recent !ears$• (n ,#ril 2;;H' the glo al forex %arket traded' ?9'20;

illion #er da! in c"rrenc!$• The three %a8or foreign exchange centers are located in

the United 1ingdo%' the United States' and :a#an$• Kther i%#ortant centers for forex trade incl"de Dong

1ong' Iaris' Singa#ore' S!dne!' and "rich$• Thanks to ti%e- one differences' there is not a %o%ent

in the da! when foreign exchange is not eing tradedso%ewhere in the world$

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Foreign Exchange Market

• The si%#lest forex transaction is a contract for thei%%ediate exchange of one c"rrenc! for anotheretween two #arties$ This is known as a s#ot contract$

• The exchange rate for this transaction is often called the

s#ot exchange rate$• (n this ook' the "se of the ter% Pexchange rateQ alwa!srefers to the s#ot rate$

• Technolog! toda! red"ces the risk of one #art! failing to

deli&er on its side of the transaction default risk orsettlement risk . is essentiall! ero$• The s#ot contract is the %ost co%%on t!#e of trade and

a##ears in al%ost =; of all forex transactions$

The S#ot Contract

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Foreign Exchange Market3eri&ati&es

S#ot and Forward RatesThe chart shows the U$S$s#ot and three-%onthforward exchange rates forthe e"ro in dollars #er e"roin the !ear 2;;>$The s#ot and forward ratesclosel! track each other$

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• (n addition to the s#ot contract there are %an! otherrelated forex contracts' incl"ding forwards' swa#s'f"t"res' and o#tions$ Collecti&el!' all these relatedforex contracts are ter%ed deri&ati&es$

•The forex deri&ati&es %arket is s%all relati&e to theentire glo al forex %arket$

3eri&ati&es

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,IIL(C,T(KForeign Exchange 3eri&ati&esF"t"res , f"t"res contract is a #ro%ise that the two #artiesholding the contract will deli&er c"rrencies to each other atso%e f"t"re date at a #res#ecified exchange rate' 8"st likea forward contract$ Unlike the forward contract' howe&er'f"t"res contracts are standardi ed' %at"re at certainreg"lar dates' and can e traded on an organi ed f"t"resexchange$K#tions ,n o#tion #ro&ides one #art!' the "!er' with theright to "! call . or sell put . a c"rrenc! in exchange for

another at a #res#ecified exchange rate at a f"t"re date$The "!er is "nder no o ligation to trade and' in #artic"lar'will not exercise the o#tion if the s#ot #rice on theex#iration date t"rns o"t to e %ore fa&ora le$

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,IIL(C,T(KForeign Exchange 3eri&ati&es3eri&ati&es allow in&estors to engage in hedging riska&oidance. and speculation risk taking.$J Exa%#le 0* Dedging$ ,s chief financial officer of a U$S$fir%' !o" ex#ect to recei&e #a!%ent of 60 %illion in =; da!sfor ex#orts to France$ The c"rrent s#ot rate is ?0$2; #ere"ro$ o"r fir% will inc"r losses on the deal if the dollarweakens to less than ?0$0; #er e"ro$ o" ad&ise that thefir% "! 60 %illion in call o#tions on dollars at a rate of?0$0A #er e"ro' ens"ring that the fir% s e"ro recei#ts will

sell for at least this rate$ This locks in a %ini%al #rofit e&enif the s#ot rate falls elow ?0$0A$ This is hedging$

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,IIL(C,T(KForeign Exchange 3eri&ati&es3eri&ati&es allow in&estors to engage in hedging riska&oidance. and speculation risk taking.$J Exa%#le 2* S#ec"lation$ The %arket c"rrentl! #ricesone-!ear e"ro f"t"res at ?0$9;' "t !o" think the dollar willweaken to ?0$49 in the next 02 %onths$ (f !o" wish to%ake a et' !o" wo"ld "! these f"t"res' and if !o" are#ro&ed right' !o" will reali e a 0; #rofit$ ,n! le&el a o&e?0$9; will generate a #rofit$ (f the dollar is at or elow ?0$9;a !ear fro% now' howe&er' !o"r in&est%ent in f"t"res will

e a total loss$ This is s#ec"lation$ J

F i E h M k

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• The ke! actors in the forex %arket are the traders$ Mostforex traders work for co%%ercial anks$

• (nter ank trading is highl! concentrated* a o"t three-/"arters of all forex %arket transactions glo all! arehandled ! 8"st ten anks$

• The &ast %a8orit! of forex transactions are #rofit-dri&eninter ank trades' and it is the exchange rates for thesetrades that "nderlie /"oted %arket exchange rates$

• So%e cor#orations %a! trade in the %arket if the! areengaged in extensi&e transactions either to "! in#"ts orsell #rod"cts in foreign %arkets$ Si%ilarl!' so%enon ank financial instit"tions s"ch as %"t"al f"ndco%#anies %a! fa&or setting "# their own foreign

exchange trading o#erations$

Iri&ate ,ctors

F i E h M k

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• , go&ern%ent %a! tr! to co%#letel! control the %arket! #re&enting its free o#eration' ! restricting trading or

%o&e%ent of forex' or ! allowing the trading of forexonl! thro"gh go&ern%ent channels$ Iolicies of this kindare a for% of ca#ital control' a restriction on cross-

order financial transactions$• The go&ern%ent %a! set "# an official %arket for foreign

exchange and iss"e a law re/"iring #eo#le to "! andsell in that %arket at officiall! set rates$ +"t illicit

dealings can #ersist Pon the streetQ in lack %arkets or parallel markets where indi&id"als %a! trade atexchange rates deter%ined ! %arket forces$

o&ern%ent ,ctions

F i E h M k

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• , less drastic action taken ! the a"thorities is to let the#ri&ate %arket for foreign exchange f"nction "t to fix orcontrol forex #rices in the %arket thro"gh inter&ention' a

8o t!#icall! gi&en to a nation s central ank$• To %aintain a fixed exchange rate' the central ank %"st

stand read! to "! or sell its own c"rrenc!' in exchangefor the ase foreign c"rrenc!' at a fixed #rice$

• (n #ractice' kee#ing so%e foreign c"rrenc! reser&es%a! e costl! and "ncertain' as reso"rces are tied "# inforeign c"rrenc! and reser&es %a! r"n o"t$

o&ern%ent ,ctions

i d S# E h R

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,r itrage and S#ot Exchange Rates• The %ost asic of acti&ities #"rs"ed ! #ri&ate actors in

an! %arket is ar itrage' a trading strateg! that ex#loitsan! #rofit o##ort"nities arising fro% #rice differences$

• (n the si%#lest ter%s' ar itrage %eans to "! low andsell high$ (f s"ch #rofit o##ort"nities exist in a %arket'then it is considered to e o"t of e/"ili ri"%$ (f no s"ch#rofit o##ort"nities exist' there will e no ar itrageN the%arket is in e/"ili ri"% and satisfies a no-ar itragecondition$

it d S# t E h R t

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,r itrage and S#ot Exchange Rates

,r itrage and S#ot Rates ,r itrage ens"res that the trade of c"rrencies in ework along the #ath ,+ occ"rs at the sa%e exchange rate as &ia London along

#ath ,C3+$ ,t + the #o"nds recei&ed %"st e the sa%e$ Regardless of the ro"tetaken to get to +' $ E £/$

N.Y. = E £/$London

it d S# t E h R t

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• Triang"lar ar itrage works as follows* !o" sell dollars in exchangefor e"ros' then i%%ediatel! sell the sa%e e"ros in exchange for#o"nds$

• (n general' three o"tco%es are again #ossi le$ The direct tradefro% dollars to #o"nds has a etter rate* E 5? V E 56 E 65?N the indirecttrade has a etter rate* E 5? WE 56 E 65?N or the two trades ha&e thesa%e rate and !ield the sa%e res"lt* E 5? @E 56 E 65?$ Knl! in the lastcase are there no #rofit o##ort"nities$ This no-ar itrage condition*

,r itrage with Three C"rrencies

rateCross

€/$

€/£$/ € €/£

rateexchangeDirect

$/£

E

E E E E ==

• The right-hand ex#ression' a ratio of two exchange rates' is called across rate$

it d S# t E h R t

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,r itrage and Cross Rates Triang"lar ar itrage ens"res that the direct trade ofc"rrencies along the #ath ,+ occ"rs at the sa%e exchange rate as &ia a thirdc"rrenc! along #ath ,C+$ The e"ros recei&ed at + %"st e the sa%e on oth#aths' and $/ € €/£$/£ E E E =

it g d S# t E h g R t

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• There are 0

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,r itrage and (nterest Rates• ,n i%#ortant /"estion for in&estors is in which c"rrenc!

the! sho"ld hold their li/"id cash alances$• )o"ld selling e"ro de#osits and "!ing dollar de#osits

%ake a #rofit for a ankerX 3ecisions like these dri&e thede%and for dollars &ers"s e"ros and the exchange rate

etween the two c"rrencies$• The Iro le% of Risk , trader in ew ork' and her ank

care a o"t ret"rns in U$S$ dollars$ , dollar de#osit #a!s aknown ret"rn' in dollars$ +"t a e"ro de#osit #a!s a ret"rnin e"ros' and one !ear fro% now we cannot know for

s"re what the dollar-e"ro exchange rate will e$• Riskless arbitrage and risky arbitrage lead to two

i%#ortant i%#lications' called parity conditions $

r itr ge nd (nterest R tes

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,r itrage and (nterest Rates

• S"##ose that contracts to exchange e"ros for dollars inone !ear s ti%e carr! an exchange rate of F ?5 6 dollars#er e"ro$ This is known as the forward exchange rate$

• (f !o" in&est in a dollar de#osit' !o"r ?0 #laced in a U$S$ank acco"nt will e worth 0 i

?. dollars in one !ear s

ti%e$ The dollar &al"e of #rinci#al and interest for theU$S$ dollar ank de#osit is called the dollar return.

• (f !o" in&est in a e"ro de#osit' !o" first need to con&ertthe dollar to e"ros$ Using the s#ot exchange rate' ?0

"!s 05 E ?5 6 e"ros toda!$ These 05 E ?5 6 e"ros wo"ld e#laced in a e"ro acco"nt earning i 6' so in a !ear s ti%ethe! wo"ld e worth 0 i 6.5E ?5 6 e"ros$

Riskless ,r itrage* Co&ered (nterest Iarit!

r itrage and (nterest Rates

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• To a&oid that risk' !o" engage in a forward contract toda!to %ake the f"t"re transaction at a forward rate F ?5 6$ The

0 i 6.5E ?5 6 e"ros !o" will ha&e in one !ear s ti%e canthen e exchanged for 0 i 6.F ?5 65E ?5 6 dollars' or thedollar ret"rn on the e"ro ank de#osit$

Riskless ,r itrage* Co&ered (nterest Iarit!

( ) ( )

de ositse!roonret!rnDollar

€/$

€/$ €

de ositsdollaronret!rnDollar

$ 11 E F

ii +=+

• This ex#ression is called co&ered interest #arit! C(I.eca"se all exchange rate risk on the e"ro side haseen Pco&eredQ ! "se of the forward contract$ )e sa!

that s"ch a trade e%#lo!s forward cover.


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,r itrage and Co&ered (nterest Iarit! Under C(I' ret"rns to holding dollar de#ositsaccr"ing interest going along the #ath ,+ %"st e/"al the ret"rns fro% in&esting ine"ros going along the #ath ,C3+ with risk re%o&ed ! "se of a forward contract$Dence' at +' the riskless #a!off %"st e the sa%e on oth #aths' and

$( ) ( ) €

€/$

€/$$ 11 i E

F i +=+


IIL(C T(K

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,IIL(C,T(KE&idence on Co&ered (nterest Iarit!

Financial Li erali ation and Co&ered (nterest Iarit!* ,r itrage etween the United1ingdo% and er%an! The chart shows the difference in %onthl! #o"nd ret"rns onde#osits in +ritish #o"nds and er%an %arks "sing forward co&er fro% 0=H; to 0==A$ (n the0=H;s' the difference was #ositi&e and often large* traders wo"ld ha&e #rofited fro%ar itrage ! %o&ing %one! fro% #o"nd de#osits to %ark de#osits' "t ca#ital controls

#re&ented the% fro% freel! doing so$

IIL(C T(K

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,IIL(C,T(KE&idence on Co&ered (nterest Iarit!

Financial Li erali ation and Co&ered (nterest Iarit!* ,r itrage etween the United1ingdo% and er%an! contin"ed.

,fter financial li erali ation' these #rofits essentiall! &anished' and no ar itrageo##ort"nities re%ained$ The C(I condition held' aside fro% s%all de&iationsres"lting fro% transactions costs and %eas"re%ent errors$

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,r itrage and Unco&ered (nterest Iarit! Under C(I' ret"rns to holding dollarde#osits accr"ing interest going along the #ath ,+ %"st e/"al ret"rns fro%in&esting in e"ros going along the risk! #ath ,C3+$ Dence' at +' the ex#ected#a!off %"st e the sa%e on oth #aths' and

$( ) ( ) €

€/$

€/$$ 11 i E

E i

e

+=+



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)hat 3eter%ines the S#ot RateX Unco&ered interest #arit!is a no-ar itrage condition that descri es a e/"ili ri"% inwhich in&estors are indifferent etween the ret"rns on"nhedged interest- earing ank de#osits in two c"rrencies

where forward contracts are not e%#lo!ed.$ )e can rearrange the ter%s in the "nco&ered interest #arit!ex#ression to sol&e for the s#ot rate*

Riskless ,r itrage* Unco&ered (nterest Iarit!

$

€ €/$ €/$

1

1

i

i E E e

+

+=


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,ssets and Their ,ttri "tes• ,n in&estor s entire #ortfolio of assets %a! incl"de stocks' onds'real estate' art' ank de#osits in &ario"s c"rrencies' and so on$ ,llassets ha&e three ke! attri "tes that infl"ence de%and* ret"rn' risk'and li/"idit!$

• ,n asset s rate of ret"rn is the total net increase in wealth res"ltingfro% holding the asset for a s#ecified #eriod of ti%e' t!#icall! one!ear$•The risk of an asset refers to the &olatilit! of its rate of ret"rn$

•The li/"idit! of an asset refers to the ease and s#eed with which itcan e li/"idated' or sold$•)e refer to the forecast of the rate of ret"rn as the ex#ected rate ofret"rn$

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IIL(C T(K

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,IIL(C,T(KE&idence on Unco&ered (nterest Iarit!• 3i&iding the U(I ! the C(I' we o tain ' or

$ Th"s' we see that altho"gh the ex#ectedf"t"re s#ot rate and the forward rate are "sed in twodifferent for%s of ar itrage risk! and riskless' ine/"ili ri"% the! sho"ld not differ at allN the! sho"ld e

exactl! the sa%eY• (f oth co&ered interest #arit! and "nco&ered interest

#arit! hold' the forward %"st e/"al the ex#ected f"t"res#ot rate$ (n&estors ha&e no reason to #refer to a&oid

risk ! "sing the forward rate' or to e% race risk !awaiting the f"t"re s#ot rate$

€/$ €/$ /1 F E e=

€/$ €/$ F E e =

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IIL(C T(K

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,IIL(C,T(KE&idence on Unco&ered (nterest Iarit!

E&idence on (nterest Iarit! )hen U(I and C(I hold' the02-%onth forward #re%i"%sho"ld e/"al the 02-%onthex#ected rate of de#reciation$

, scatter#lot showing thesetwo &aria les sho"ld e closeto the diagonal 4A-degreeline$Using e&idence fro% s"r&e!sof indi&id"al forex tradersex#ectations o&er the #eriod

0=>> to 0==9' U(I finds so%es"##ort' as the line of est fitis close to the diagonal$


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• The U(I a##roxi%ation e/"ation sa!s that the ho%einterest rate e/"als the foreign interest rate #l"s theex#ected rate of de#reciation of the ho%e c"rrenc!$

• For exa%#le' s"##ose the dollar interest rate is 4 #er !ear andthe e"ro interest rate 9 #er !ear$ (f U(I is to hold' then theex#ected rate of dollar de#reciation o&er a !ear %"st e 0 $ Thetotal dollar ret"rn on the e"ro de#osit is a##roxi%atel! e/"al tothe 4 that is offered ! dollar de#osits$

Unco&ered (nterest Iarit!* , Usef"l ,##roxi%ation

de ositse!roon

ret!rnof ratedollarx ected

dollar theof onde reciatiof ratex ected

€/$

€/$

de ositse!roonrate&nterest

€

de ositsdollaronret!rnof rateDollar

=de ositsdollaron

rate&nterest

$ E E ii

e

∆+=


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,r itrage and (nterest RatesS"%%ar!

Dow (nterest Iarit! Relationshi#s Ex#lain S#ot and Forward Rates(n the s#ot %arket' U(I #ro&ides a %odel of how the s#ot exchange rate isdeter%ined$ To "se U(I to find the s#ot rate' we need to know the ex#ected f"t"res#ot rate and the #re&ailing interest rates for the two c"rrencies$


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,r itrage and (nterest RatesS"%%ar!

Dow (nterest Iarit! Relationshi#s Ex#lain S#ot and Forward Rates(n the forward %arket' C(I #ro&ides a %odel of how the forward exchange rate isdeter%ined$ )hen we "se C(I' we deri&e the forward rate fro% the c"rrent s#otrate fro% U(I. and the interest rates for the two c"rrencies$

lecture 2 - 4

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Transcript of lecture 2 - 4