interest rate parity

RMB Prospect

RMB forwardsAround the Interest Rate Parity

Interest rate parity (IRP)According to the theory, forward rate is determined by the interest rate difference between two countries. The rate reaches equilibrium when no arbitrage return can be obtained- The 3 month forward rate will be used in the following study

The theory often does not hold due to imperfect capital circulation, risk premium, and external shocks (e.g. market panic)

Risk premium can be isolated by referring to Australias case

Australia case

The deviance from IRP is small, around 200bpDeviance hiked in 2000 and 2007Dot.com bubble and 08 financial crisisReturn to 20bp very quickly (around 2 years)

Australia caseAUD is known for its liquidity and a well-developed marketA stable 20bp deviation can thus be approximated to be the risk premiumThe case in China, however, is much more complex

China caseSource: Bloomberg & Wind. Data as of 5/8/15

China case1. A larger deviance from IRP very likely caused by the capital control and the under-developed market system2. Reverse of the deviation from negative to positiveMarket values USD higher than the theory

Source: Bloomberg & Wind. Data as of 5/8/15

China caseThe deviance rises from September 2007 as well as March 2008Caused by market expectation that IRP does not capturedSource: Bloomberg & Wind. Data as of 5/8/15

China case2007 Sep PBOC raise RMB deposit basis rate and Fed lowered USD basis rateIt was the beginning of the 08 crisis and market expected USD to further devalue; real rate values USD lower than IRP

Source: Bloomberg & Wind. Data as of 5/8/15

China caseBy 2008 March, Fed has already lowered the rate 6 timesCrisis was almost resolved and market expect an USD appreciationMarket valued the USD higher than IRP and induced the negative deviation

Source: Bloomberg & Wind. Data as of 5/8/15

Implication of Chinas deviationComposition of the deviance:From the previous slides, we can see that market expectation was vitalThe deviation can be approximated as the difference between markets expectation on RMB and on yields of US assets (what IRP based)Nature of RMB as a Forex:Young; lack historical trend to be studied by investorsIntervention by the PBOC on the exchange rate against US

Deviance as an indicatorDeviance predicting future trend of spot rate:Investors lack historical data and can only refer to previous spot rate changes (which they presume is the result of PBOCs intervention)The deviance between real forward rate and IRP can isolates the factors IRP doesnt consider:Government intervention and market sentimentsThe factors isolated determines RMB trading activities and thus the spot rateA larger deviance(theory real) means market expecting the spot rate to drop given PBOCs adjustments in previous daysThe chart below illustrate the spot rates slightly lag, negative-correlated movement with the devianceSource: Bloomberg & Wind. Data as of 5/8/15

Profit with NDFProfit formula: Total profit = offshore NDF spot + onshore rmb deposit yield offshore foreign currency loan interest (also deduct transaction fee)Shorter term NDF has a very small profit (~0) and 1 year NDF may yieldcertain profit yet subjected to larger transaction costLonger term operation with NDF is recommended under interest rate fluctuation

Source: Bloomberg & Wind. Data as of 5/8/15

Hedging with NDFNDF is very sensitive to external factors and market expectationsHedging/profiting can be achieved by holding opposite positions of both NDF and onshore forwards When NDF appreciate against onshore deliverable forward (DF), investor can short USD and long RMB via DF and long USD and short RMB via NDFSource: Bloomberg & Wind. Data as of 5/8/15

RMB prospectIn the late 2015 the deviance shows a falling trend3 month forward rate exceeds 3 month rate by IRP by around 600bpMarket expects a devaluation of RMBThe recent RMB devaluation can thus fulfill the expectation and according to previous discussion may even lower the spot rate laterSource: Bloomberg & Wind. Data as of 5/8/15

RMB prospectTrend of the deviance from IRP, and thus the spot rate, from can be predicted given the expectation non PBOCs policyA loose monetary policy may stirred expectation of devaluation and bigger devianceThe internationalization and liberalization of RMB, however, may gradually close the deviance to near AUDs level, and produced a predictable trendExternal shocks, however, are very likely to occur and can hinder the above theories.Source: Bloomberg & Wind. Data as of 5/8/15