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  • Handout #7

    International Parity ConditionsInterest Rate Parity and the Fisher Parities

    Yee-Tien Ted Fu

    Tuesdays 6:10-9:00 p.m.Commerce 260306

    Wednesdays 9:10 a.m.-12 noonCommerce 260508

    Course web pages:http://finance2010.pageout.net

    ID: California2010 Password: blueskyID: Oregon2010 Password: greenland

  • 5-2

    Levich

    Luenberger

    Solnik

    Eun

    Wooldridge

    Additional Reading Assignments for this Week

    Chap 5

    Chap

    Chap 2

    Chap 7

    Scan Read

    Pages

    Pages

    Pages

    Pages

    Chap 9 Pages

    Foreign Exchange Parity Relations

    International Parity Conditions

    Multiple Regression Analysis with Qualitative Information: Binary (or Dummy) Variables

    http://highered.mcgraw-hill.com/sites/dl/free/0072521279/91312/eun21279_ch09_dr.pdf

  • 5-3

    World Interest Rates Table

    7.25%Mar 04 2008Aug 05 2008The Reserve Bank of Australia

    2.75%Sep 13 2007Sep 18 2008Swiss National Bank

    2%Apr 30 2008Aug 05 2008Federal Reserve

    4.25%Jul 03 2008Aug 07 2008European Central Bank

    0.5%Feb 21 2007Jul 15 2008Bank of Japan

    5%Apr 10 2008Jul 10 2008Bank of England

    3%Apr 22 2008Jul 15 2008Bank of Canada

    Current Interest RateLast ChangeNext MeetingCentral Bank

    Major Central Banks Overview

    http://www.fxstreet.com/fundamental/interest-rates-table/

  • 5-4

  • 5-5

    http://finance.mapsofworld.com/financial-market/world-inflation.htmlhttp://inflationdata.com/inflation/Inflation_Rate/InternationalSites.asp

  • 5-6

    Exchange Rates Table

    http://www.x-rates.com/

  • 5-7

  • 5-8

    July 2007

    http://www.economist.com/markets/bigmac/

  • 5-9

    June 24, 2008

    http://www.economist.com/markets/bigmac/

  • 5-10

    Feb 04, 2009

    http://www.economist.com/markets/bigmac/

  • 5-11

    International Parity Relations Linear Approximationwhere Spot Rate S are in indirect quote (FC/DC or FC/$)

    Solnik 2.1

    Interest Rate Parity

    Forward Rate Unbiased Property

    Uncovered Interest Parityor Fisher International Effect

    Purchasing Power Parity (relative version) PPP

    IRPFIE

    FRU

  • 5-12

    Source: Page 129 of Levich 2E

    It takes three to five years to see a significant (+)(-)valuation to be cut in half.

  • Foreign Exchange MarketsInternational Parity Conditions

    Interest Rate Parity and the Fisher Parities

    MS&E 247S International InvestmentsYee-Tien (Ted) Fu

  • 5-14

    The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us when the storm is long past, the ocean will be flat.

    - John Maynard Keynes

    Long-Run versus Short-Run

  • 5-15

    Building Blocks of The Parity Framework

    The Parity Framework

    Four Definitions: S, F, r, I

    Four Derived Key Terms: rF - rD, IF - ID,f, s

    Purchasing Power Parity + Uncovered Interest Parity (Fisher International Effect)

    Forward Rate Unbiased Property + Interest Rate Parity

    Key Interest Exchange Rates Linkages

  • 5-16

    Four DefinitionsThe spot exchange rate, S. The rate of exchange of two currencies tells us the amount of foreign currency that one unitof domestic currency can buy. Spot means that we refer to the exchange rate for immediate delivery.The forward exchange rate, F. The rate of exchange of two currencies set on one date for delivery at a future specified date, the forward rate is quoted today for a delivery taking place at a future date.The interest rate, r. The rate of interest for a given time period is a function of the length of the time period and the denomination of the currency. Interest rates are usually quoted in the market place as an annualized rate.The inflation rate, I. This is equal to the rate of consumer price increase over the period specified. The inflation differential is equal to the difference of inflation rates between two countries.

  • 5-17

    The interest rate differential, rF - rD. The interest rate differential is equal to the difference in interest rates between two countries.

    The inflation differential, IF - ID. The inflation differential is equal to the difference of inflation rates between two countries.

    The forward discount or premium, f. This is often calculated as an annualized percentage deviation from the spot rate:

    The exchange rate movement, s. This is equal to the spot exchange rate movement over the period specified. f = (F-S0)/S0 and s = (S1-S0)/S0

    Four Derived Key Terms

    annualized forward premium (discount)

    forward rate - spot ratespot rate

    = 100 %12no. months forward

  • 5-18

    F0,1

    F0,2

    F1,1

    F1,2

    t = 0 1 2 3 n

    S1S0 S2 S3

    Forward exchange rate premium f = (F-S0)/S0

    Exchange rate movement over the period specified

    s = (S1-S0)/S0

    Spot rate: S0 = S current timeForward rate: F0,1 = F contract signing time, time to maturity

  • 5-19

    You operate a sesame oil plant, buying sesame seeds and produce sesame oil out of it. You have an MBA degree and you learned in your finance course that you should obtain price forecast from commodity futures market. You just found on the futures market that the futures price of sesame seeds and sesame oil are about the same next year. How should you modify your production plan for the next year? Should you contract out / swap your next years capacity to another oil plant? Should you mothball your business for one year? Should you upgrade to other value-adding and profitable operations? What other key information (e.g., futures price for ten years into the future) may also help you make a prudent and informed decision?

  • 5-20

    Parity conditions are useful when parity holds Parity conditions are useful when parity does not hold

    Key Interest Rate-Exchange Rate Linkages: The Parity Framework

    Please note that parity conditions are long-term equilibrium conditions. It might not happen in the near future (e.g., in three months) but it more likely to happen in the long-run (e.g., in six years).

  • 5-21

    Four International Parity ConditionsPurchasing Power Paritylinking spot exchange rates and inflationAbsolute PPP: The price of a market basket of U.S. goods equals the price of a market basket of foreign goods when multiplied by the exchange rate.Relative PPP: The percentage change in the exchange rate equals the percentage change in U.S. goods prices less the percentage change in foreign goods prices.

    Uncovered Interest Paritylinking interest rates and inflationFisher Effect: For a single economy, the nominal interest rate equals the real interest rate plus the expected rate of inflation.International Fisher Effect: For two economies, the U.S. interest rate minus the foreign interest rate equals the expected difference of inflation rates between two countries.

  • 5-22

    Interest Rate Paritylinking forward exchange rates and expected spot exchange rate The forward exchange rate premium equals (approximately) the U.S. interest rate minus the foreign interest rate.

    Forward Rate Unbiased Propertylinking forward exchange rates and expected spot exchange ratesForeign Exchange Expectations: Todays forward premium (for delivery in n days) equals the expected percentage change in the spot rate (over the next n days).

    Four International Parity Conditions

  • 5-23

    International Parity Relations Linear Approximationwhere Spot Rate S are in indirect quote (FC/DC or FC/$)

    Solnik 2.1

    Interest Rate Parity

    Forward Rate Unbiased Property

    Uncovered Interest Parityor Fisher International Effect

    Purchasing Power Parity (relative version) PPP

    IRPFIE

    FRU

  • 5-24

    We will now look at the parity conditions that link the spot and forward exchange markets with the international money and bond markets.

    We first develop the parity conditions in a theoretical setting, starting with the perfect capital market (PCM) assumptions. Then we analyze the impact of relaxing the PCM assumptions (e.g., no taxes, complete certainty).

    Parity Conditions

  • 5-25

    We will begin with interest rate parity. The interest rate parity condition offers us an easy opportunity to relax the PCM assumptions and show the effect of introducing taxes into our financial calculations.

    Secondly, we present the Fisher parities, named after Irving Fisher who derived these relationships in the late 19th century.

    Thirdly, we introduce the forward rate unbiased condition as the final parity relationship.

    Parity Conditions

  • 5-26

    While PPP involves arbitrage in goods, the other three parity conditions involve arbitrage opportunities in financial markets where transaction costs are usually lower.

    However, financial markets are often subjected to controls or restrictions and taxes that limit the ability of market participants to complete an arbitrage transaction.

    The Usefulness of theParity Conditions

  • 5-27

    When controls or taxes that are present create a deviation from a parity condition, the magnitude of the deviation reveals how profitable it will be for an agent to overcome that control or tax.

    The Usefulness of theParity Conditions

  • 5-28

    As with PPP, financial market transactions often involve risk. Some of the risks, such as price risk, credit risk, country risk, etc., may apply to the parity fi

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