global investments ppt presentation

8/13/2019 Global Investments PPT Presentation

1/48

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Chapter 2

Foreign

Exchange

Parity

Relations


2/48

Copyright 2009 Pearson Prentice Hall. All rights reserved. 2 - 2

Introduction

In this chapter we look at:

Foreign exchange fundamentals; in particular

the balance of payments and exchange rate

regimes. Describe the factors that cause a nations

currency to appreciate or depreciate.

International parity relations.

Define and discuss the International Fisher

relation.


3/48


Introduction

Discuss the implications of the parity

relationships combined.

Exchange rate determination theories and their

potential implications. Discuss the asset markets approach to pricing

exchange rate expectations.


4/48


Supply and Demand for Foreign

Exchange

In general, there are many types oftransactions that affect the demand and

supply of one national currency.

From an accounting viewpoint, eachcountry keeps track of the payments on all

international transactions in its balance of

payments.


5/48


Exhibit 2.1: Foreign Exchange Market

Equilibrium


6/48


Balance of Payments

The balance of payments tracks all financialflows crossing a countrys borders during a

given period (a quarter or a year).

A balance of payments is not an incomestatement nor a balance sheet.

The convention is to treat all financial

inflows as a credit to the balance ofpayments.


7/48Copyright 2009 Pearson Prentice Hall. All rights reserved. 2 - 7

Balance of Payments

An export, for example, creates a financialinflow for the home country, whereas an

import creates an outflow.

There are two main categories:

Current account

Financial account



Current Account

Covers all current transactions that take place inthe normal business of residents of a country.

Dominated by the trade balance, the balance of allexports and imports.

Made up of:

Exports and imports (trade balance)

Services

Income

Current transfers



Current Account

It also covers: Services (such as services in transportation,

communication, insurance and finance).

Income (interest, dividends and various investment

income from cross-border investments). Current transfers (flows without quid pro quo

compensation).

A current account deficit is not necessarily a bad

economic signal as long as nonresidents arewilling to offset it by investment flows.



Financial Account

Covers investments by residents abroad andinvestments by nonresidents in the home country.

It includes:

Direct investment made by companies.

Portfolio investments in equity, bonds and other

securities of any maturity.

Other investments and liabilities (such as deposits or

borrowing with foreign banks and vice versa).



Financial Account

The sum of the current and financialaccounts should be zero.

Question: What if the overall balance is

negative?

Answer: The central bank can use up part of

its reserves to restore a zero balance.



Capital and Financial Account

The Capital Accountincludes unrequited(unilateral) transfers corresponding to capital

flows without compensation such as foreign aid,

debt forgiveness and expropriation losses. This is

typically a very small account with a misleading

title. It is often aggregated with the financial

account (capital and financial account).



Capital and Financial Account

Similarly,Net Errors and Omissions(orstatistical discrepancy) are usually

aggregated with the capital and financial

account. To be sustained, a current account deficit

must be financed by a financial account

surplus.


14/48


Exhibit 2.2: U.S. Balance of Payments

for 2004


15/48


Balance of Payments Equilibrium

The sum of the current account and of the capitaland financial account is called the overall balance

and should be zero in the absence of government

intervention.

The official reserve account tracks all reserve

transactions by the monetary authorities.

By accounting definition, the overall balance must

mirror the official reserve account.


16/48


Differences in Economic Performance

Financial flows are attracted by highexpected return, but also by low risk.

Desired Attributes:

A stable political system

A rigorous but fair legal system

A fair tax system

Free movements of capital


17/48


Factors That Cause a Nations Currency

to Appreciate or Depreciate

In a flexible exchange rate system, the valueof a currency is driven by changes in

fundamental economic factors.

Amongst the factors are: Differences in national inflation rates.

Changes in real interest rates.

Differences in economic performance. Changes in investment climate.


18/48


19/48


Exchange Rate Regimes

Historically, there have been three differentregimes:

Flexible (or Floating) Exchange Rates

Fixed Exchange Rates

Pegged Exchange Rates


20/48


Flexible (Floating) Exchange Rate

Regime

One in which the exchange rate between twocurrencies fluctuates freely in the foreignexchange market.

Advantage

The exchange rate is a market-determined price thatreflects economic fundamentals at each point in time.

Governments are free to adopt independent domesticmonetary and fiscal policies.

Disadvantage Quite volatile exchange rates.


21/48


Fixed Exchange Rate Regime

One in which the exchange rate between twocurrencies remains fixed at a preset level, knownas official parity.

Advantages:

Eliminates exchange rate risk, at least in the short run.

Brings discipline to government policies.

Disadvantages:

Deprives the country of any monetary independence.

Also constrains countrys fiscal policy.

Its long-term credibility


22/48


Currency Board

Today some countries try to maintain afixed exchange rate regime against the

dollar or euro.

This is done through a currency board

The supply of home currency is fully

backed by an equivalent amount of that

major currency.


23/48


Pegged Exchange Rate Regime

Characterized as a compromise between a flexibleand a fixed exchange rate. The exchange rate is allowed to fluctuate within a

(small) band around a target exchange rate (peg) andthe target exchange rate is periodically revised to reflect

changes in economic fundamentals. Advantages

Reduces exchange rate volatility in the short run.

Also encourages monetary discipline for the home

country. Disadvantage

Can induce destabilizing speculation.


24/48


International Parity Relations

The parity relations of international financeare as follows:

Interest rate parity relation

Purchasing power parity relation. International Fisher relation.

Uncovered interest rate parity relation.

Foreign exchange expectation relation.


25/48


International Parity Relations: Definitions

The term spotrate (S) refers to the exchange ratefor immediate delivery.

The forward rate (F) is set on one date for

delivery at a future specified date. For example,the $: forward exchange rate for delivery in six

months might be F = 106.815 yen per dollar.

rFCand rDCare the foreign and domestic interest

rates (annualized). IFC and IDCare the foreign and domestic inflation

rates (annualized).


26/48


Interest Rate Parity Relation

Interest rate parity is the relation that theforward discount (premium) equals the

interest rate differential between two

currencies. Indicates that what we gain on the interest

rate differential, we lose on the discount on

the forward contract.


27/48


Interest Rate Parity Relation

Exact relationF/S = (1 + rFC)/(1 + rDC)

Linear approximation

= F/S -1 rFC- rDC


28/48


Parity Relations

Thepurchasing power parityrelation,linking spot exchange rates and inflation.

TheInternational Fisher relation, linking

interest rates and expected inflation. The uncovered interest rate parityrelation,

linking spot exchange rates, expectedexchange rates and interest rates.

Theforeign exchange expectation relation,linking forward exchange rates andexpected spot exchange rates.


29/48


Purchasing Power Parity (PPP) Relation

PPP states that the spot exchange rateadjusts perfectly to inflation differentials

between two countries.

There are two versions of PPP: Absolute PPP

This claims that the exchange rate should be equal

to the ratio of the average price levels in the two

economies.

Relative PPP

Focuses on the general across the board inflation

rates.


30/48



Relative PPP This claims that the percentage movement of

the exchange rate should be equal to the

inflation differential between the twoeconomies

The PPP relation is presented as:

Exact

S1/S0= (1 + IFC)/(1 + IDC)


s = S1/S01 IFC- IDC


31/48



PPP says that what you gain with lowerdomestic inflation, you can expect to lose

on foreign currency depreciation when you

invest in foreign currency assets.


32/48


International Fisher Relation

Claims that the interest rate differential between

two countries should be equal to the expected

inflation rate differential over the term of the

interest rate.

The International Fisher Relationcan be

represented as:

Exact

(1 + rFC)/(1 + rDC) = (1 + E(IFC))/(1 + E(IDC))


rFCrDCE(IFC) - E(IDC)


33/48


Example

Question:How are the nominal and realinterest rates calculated?

Answer:Nominal interest rate is observed

in the marketplace. The real interest rate iscalculated from the observed interest rate

and forecasted inflation.


34/48


Uncovered Interest Rate Parity Relation

This is a theory combining purchasing powerparity and the international Fisher relation.

It refers to the exchange rate exposure not coveredby a forward contract.

It claims the expected change in the indirectexchange rate approximately equals the foreignminus the domestic interest rate.

It can be represented as:

Exact

E(S1)/S0= (1 + rFC)/(1 + rDC)

Linear Approximation

E(s) = E(S1)/S01 rFC- rDC


35/48


Foreign Exchange Expectation Relation

This relation states that the forwardexchange rate, quoted at time 0 for delivery

at time 1, is equal to the expected value of

the spot exchange rate at time 1. This can be written as:

F = E(S1)


36/48


Combining Relations - Summary

Interest rate differential:forward discount (premium)equals the interest rate differential.

Inflation differential:exchange rate movement shouldexactly offset any inflation differential.

Expected inflation rate differential:expected inflationrate differential should be matched by the interest ratedifferential, assuming (Fisher) real interest rates areequal.

The interest rate differential:expected to be offset by thecurrency depreciation.

The expected exchange rate movement:forward discount(or premium) is equal to the expected exchange ratemovement.


37/48


Summary of Parity Relations

Exhibit 2 3: International Parity


38/48


Exhibit 2.3: International Parity

Relations Linear Approximation


39/48


Exchange Rate Determination

The following approaches are proposed: Fundamental value based on relative PPP

Balance of Payments Approach

Asset Market Approach

F d t l V l B d R l ti


40/48


Fundamental Value Based on Relative

PPP

Such estimation is not an easy task and exchangerates can become grossly misaligned and remain

so for several years without a correction.

This correctionwill usually take place, but it may

take several years and its timing is unclear.

Additional models are needed to provide a better

understanding of exchange rate movements.


41/48


42/48


Balance of Payments Approach

An analysis of balance of payments provided thefirst approach to the economic modeling of theexchange rate.

The four component groups include the current

account, financial account, capital account andofficial reserves account.

An imbalance in some account could lead to adepreciation or appreciation of the home currency.


43/48


Sources of Data for BOP

Customs data

Central bank stats

Bank reports of transactions


44/48


BOP Components

Current Account

Capital account

Financial account

Official reserve account

Exhibit 2 5: Balance of Payments


45/48


Exhibit 2.5: Balance of Payments

and the Dollar Exchange Rate


46/48


Asset Market Approach

This approach claims that the exchange rate is therelative price of two currencies, determined by

investorsexpectations about the future, not by

current trade flows.

News(unexpected information) about future

economic prospects should affect the current

exchange rate.

Several types of news influence exchange rates.

Asset Market Approach:


47/48


Asset Market Approach:

A Simple Example

Lets consider a one-time sudden and unexpected increasein the domestic money supply that will lead to higher home

inflation.

The long-runexchange rate effect is a depreciation of the

home currency so that purchasing power parity ismaintained as the percentage increase in the price level

matches the percentage increase in the money supply.

Given sticky-goods prices, theshort-runexchange rate

effect is an immediate drop in the real interest rate andmore depreciation of the currency than the depreciation

implied by purchasing power parity.

E hibi 2 6


48/48

Exhibit 2.6:

ExchangeRate

Dynamics

global investments ppt presentation

Documents