topic 3_intl parity conditions and forecasting exchange rates

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  • 8/19/2019 Topic 3_Intl Parity Conditions and Forecasting Exchange Rates

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    INTERNATIONALFINANCIAL MARKETS

    Topic 3INTERNATIONAL PARITY CONDITIONSAND FORECASTING EXCHANGE RATES

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    Outline

    1. The Parity Framework2. Law of One Price and Purchasing Power Parity

    3. Interest Rate Parity

    4. Fisher ffects and e!change rate forecasting". Forward Rate #n$iased Pro%erty

    &. m%irica' e(idences on %arity conditions

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    The P !it" F! #e$o!%

    The framework is founded u%on)assum%tions of rationa' economic $eha(iorthe a$i'ity to transact free'y at no cost in the markets for goods and

    credit as we'' as the market for foreign e!change*im%'e mode's that descri$erelationships $etween)

    the s%ot e!change ratethe forward e!change ratethe interest ratesthe inf'ation rates

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    Rele& nce n' u(e)ulne((

    m%irica' e(idence su%%orting each indi(idua' %arity conditiomi!edHow much do they hold in the real world? de%ends on the

    e!tent to which trade $arriers restrain the acti(ities of tradersfrom enforcing the 'aw of one %rice through ar$itrage+o''ecti(e'y, they constitute a usefu' way of ordering one-sthinking a$out the economic forces go(erning e!change ratemo(ements internationa' financia' benchmarks” or “break-even values”

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    L $ o) one p!ice *LOP+

    Identical goods will sell for the same price in two markets, taking intoaccount the exchange rate

    Pt/#*, wheat0 *%ott / 0 ! Pt/#5, wheat0

    !am%'e) 4."6 1."6 ! 3.66$ushe' $ushe'

    nforced $yarbitrage across markets $uying where the %roduct ischea% and se''ing where the %roduct is dearLOP can %re(ai' o(er the 'ong run due to the forces of su%%'y andemand

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    Pu!ch (in, Po$e! P !it" *PPP+

    PPP esta$'ishes a forma' 'ink $etween a country-s %rice 'e(e' orinf'ation rates 7re'ati(e to another country8 and the %re(ai'inge!change rate $etween the two countries bsolute !!! $ased on %rice 'e(e's in 2 countries)

    Pt/#*0 *%ott /#*9 :;P0 ! P t/#50

    the e!change rate wi'' ad

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    Pu!ch (in, Po$e! P !it" *PPP+

    "elative !!! $ased on %rice inde!es in 2 countries)

    The s%ot e!change rate ad

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    Pu!ch (in, Po$e! P !it" - e. #ple

    *wit>er'and inf'ation rate 4? %.a.#* inf'ation rate 2? %.a.*%ot rate6 1."6 +=F #*9

    7The #*9 wi'' a%%reciate and +=F de%reciate according'y8

    PPP %redicts a 2? a%%reciation of #*9 against +=F and a 2?de%reciation of +=F against #*9

    CHF/USD1.52951.021.04

    1.50S1PPP =×=

    2-41.9!1.021.04SPPP ≈+=−=∆ 1

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    Pu!ch (in, Po$e! P !it" Line

    :i(en an * actua')∆ *=+@F+ π =+ @π =+

    we are on the PPP 'ineand PPP ho'ds∆ *=+@F+ ≠ π =+ @π =+

    we are not on the PPP 'ineand PPP does not ho'd

    -7

    -6

    -5

    -4

    -3

    -2

    -1

    0

    1

    2

    3

    4

    5

    6

    7

    -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7

    0

    01a"t#al

    HC/FC S

    SSΔS

    =

    FCHC ππ −

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    Re l e.ch n,e ! te

    Assume π F+ Bπ =+ and π =+ is constant F+ is e!%ected to de%reciateagainst =+, according to PPP

    this does not necessari'y mean that thereal (a'ue of =+ %urchases of goods and

    ser(ices across $orders has $ecome 'owerif the increase in PF+ has e!act'y offset the dec'ine in (a'ue of the F+, then PPP wou'd remain the samethere has $een a nominal de%reciation of F+, $ut not areal de%reciation

    Chat matters for PPP across any two countries is the change in thenomina' (a'ue of a currency after ad

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    Re l e.ch n,e ! te

    These de(iations from PPP are measured using the realexchange rate and changes in real exchange rateRe l e.ch n,e ! te

    Inter%reting D (a'ues)/01 PPP ho'ds 7$enchmark (a'ue8

    /21 F+ a%%reciates in rea' terms against =+ =+ de%reciates in rea' terms against F+/ 1 F+ de%reciates in rea' terms against =+

    =+ a%%reciates in rea' terms against F+

    t$S%ot&PPP't$l'S%ot&("t#a

    )=t$S%ot&*eal' t =

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    Re l e.ch n,e ! te 4 e. #ple

    +ase 1*actua' 1."6 +=F #*9 *PPP 1."6 +=F #*9

    +=F and #*9 are attheir (a'ues

    +ase 2 *actua' 1."" +=F #*9 *PPP 1."6 +=F #*9

    #*9 o(er(a'ued+=F under(a'ued

    +ase 3 *actua' 1.4" +=F #*9 *PPP 1."6 +=F #*9

    #*9 under(a'ued+=F o(er(a'ued

    11.501.50

    ) ==

    1.01.501.55

    ) ==

    0.9!,1.501.45

    ) ==

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    Ch n,e( in !e l e.ch n,e ! te

    !am%'e)*6 1#*9 #REπ "? %.a.Eπ 16? %.a.

    PPP predicts a 4.55% depreciation of EUR a gainst USD

    PPPa"t#alPPP

    PPPa"t#al ΔSΔSS

    SSΔ) −≈−

    =

    0

    01a"t#al

    SSS −

    0

    01PPP

    SSS −

    USD/ U*0.95451.101.05

    1S1PPP =×=

    4.5511.101.05

    ΔSPPP −=−=

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    Ch n,e( in !e l e.ch n,e ! te

    !am%'e 7cont-d83 %ossi$'e cases regarding *1actua')

    *1actua' 7#*9 #R8

    ∆ *actua'7?8 ∆ *PPP7?8 ∆ D7?8 Inter%retation

    6.G"4" @4."" @4."" 6 Ho change in D6.G&66 @4.66 @4."" 6."" #Rappreciated in real

    terms $y 6.""? against#*9

    6.G"66 @".66 @4."" @6.4"? #Rdepreciated in realterms $y 6.4"? against#*9

    No#in l 'ep!eci tion o) E5R

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    NEER

    H R 7nomina' effecti(e e!change rate8tracks changes in the (a'ue of a gi(en country-s currencyre'ati(e to the currencies of its %rinci%a' trading %artnersIt is ca'cu'ated as a weighted a(erage of the $i'atera' e!changerates with those currencies.Fi(e a'ternati(e grou%s of com%etitor countries are considered$y 9: +FIH)

    a $road grou% of 41 countries 7$road grou%8a grou% of 3& industria' countries 7I+3&8a grou% of 24 industria' countries 7I+248the 2J Kem$er *tates of the uro%ean #nion 7 #8 and the euro@area countries 7 A8

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    REER

    R R 7rea' effecti(e e!change rate8aims to assess a country-s 7or currency area-s8 %rice or cost com%etiti(enessre'ati(e to its %rinci%a' com%etitors in internationa' marketsit corres%onds to the H R def'ated $y se'ected re'ati(e %rice or cost def'ators

    9ef'ators used in 9: +FIH re%orts are consumer %rice indices 7+PIand =I+P where a(ai'a$'e8, the :9P def'ator, the %rice def'ator ofe!%orts of goods and ser(ices, and unit 'a$or costs in the economy asa who'e and in the manufacturing sector

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    NEER n' REER 4 5SD

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    NEER n' REER 4 RON

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    E#pi!ic l e&i'ence( on LOP n' PPP

    LOP is fragrant'y and systematica''y (io'atedTests on PPP show that it is strong'y (io'ated on the short@run, $utdescri$es a 'ong@run %henomenonPPP does not ho'd %recise'y in the rea' wor'd for a (ariety of reasons )

    trans%ortation costse!istence of non@trada$'esdifferences in consum%tion %references

    PPP@determined e!change rates sti'' %ro(ide a (a'ua$'e $enchmarkfor)

    currency forecastingdetermining o(er@ and under@(a'uation of currenciesmanagement of foreign e!change risk

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    A te(t o) PPP - 6i, M c In'e.

    One test of the Law of One Priceis the ;ig Kac inde!, which has$een %u$'ished annua''y in#he

    %conomist since 1G &.

    It was de(ised as a 'ight@heartedguide to whether currencies areat their correctM 'e(e', $ased onPPP.

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    6i, M c In'e. 4 7ul" 8913

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    6i, M c In'e. - 7ul" 8913

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    Pit) ll( o) the 6i, M c te(t

    The ;ig Kac Inde! shows the e!tent to whichinternational pricediscrimination is %ossi$'e for a %articu'ar %roduct

    The ;ig Kac is a non@trada$'e and nondura$'e %roductIt is a differentiated %roduct with an im%'ied warranty associated w

    the re%utation of the Kc9ona'd-s +or%.;ig Kacs are genera''y %roduced 'oca''y, with 'oca' 'a$or and on 'oca''and, usua''y with 'oca''y %roduced materia'sIn many countries, ;ig Kacs do not ha(e c'ose su$stitutes

    Kc9ona'd-s sets the profit-maximi&ing price in a country, ignoring the%ros%ect of ;ig Kac ar$itrage

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    E#pi!ic l e&i'ence( )o! PPP 4 5SD:E5R

    Source: Bekaert and Hodrick, 2011

    Overvaluation of US ! 40"7# $%e& 1'(5)

    *** +ati+fied at 1"16US -U. in /an 1'''

    25"'# overvaluation of

    US $Oct 2000)

    *eak of -U.overvaluation $/ul200()

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    Inte!e(t ! te p !it" 7IRP8 states that the forward %remium or discount fthe Duoted currency ref'ects the difference in interest rates for $ankinde%osits in the two currencies

    #he currency with the higher interest rate is at a discount, the one with thelower interest rate is at a premiumIf IRP did not ho'd, then it wou'd $e %ossi$'e for an ar$itrageur to makmoney e!%'oiting the ar$itrage o%%ortunity covered interest arbitrage

    Inte!e(t ! te p !it"

    )i+(1S

    F=)i+(1 FC

    C!FC

    C!FCC

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    E#pi!ic l e&i'ence( on IRP

    Narious em%irica' studies indicate that IRP ho'ds in free, deregu'atemarkets 7within a transaction cost $and89e(iations may occur due to

    ca%ita' contro's

    ta!es 7on re%atriated ca%ita'8market incom%'eteness

    uite 'arge de(iations in c'osed 'ess@de(e'o%ed countries, since sma''ercurrencies can $e $orrowed and 'ent on'y domestica''y

    ;ankers often use IRP to Duote forward rates

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    E#pi!ic l e&i'ence( on IRP

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    CIA oppo!tunitie( 'u!in, the c!i(i(

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    The Fi(he! E))ect(

    Fisher %arities descri$e how information regarding e!%ected inf'ation ae!%ected e!change rates are ca%tured in interest ratesFi(he! clo(e' eDuation thatlinks nominal interest rate and inflationexpectations for a single economy

    Fisher c'osed re%resents another e!am%'e of ar$itrage $etween rea'assets and financia' assets within a sing'e economy

    $a ro i3ation)

    π$&1r$&1i&1 +×+=+ )

    πri +=

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    The Inte!n tion l Fi(he! E))ect *Fi(he! Open o! 5IP+

    Interest rates across countries must $e set with an eye towarde!%ected e!change rate changesThe deri(ation of IF is another straightforward a%%'ication of ar$itrage

    an interest ar$itrage $utuncovered

    the expected spot exchange rate between two currencies shouldchange by an e$ual amount but in opposite direction to thedifference in interest rates between the two countries

    ? e!%ected e!change ? interest differentia' rate change

    i-iS

    S-$&Sela%%ro i atori+1i+1=

    S&S

    FCHC0

    01

    FC

    HC

    0

    1 ≈)

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    IFE n' e.ch n,e ! te p!e'iction(

    I'% predictions=+ interest rates B F+ interest rates H( is expected to depreciate

    7*18 B *6 'ogic) in(estors must $e %aid a higher interest rate tocom%ensate them for a unit of account that is e!%ected to de%reciatein (a'ue=+ interest rates Q F+ interest rates H( is expected to appreciate

    7*18 Q *6 'ogic) in(estors wi''ing'y acce%t a 'ower interest rate when they ho'd a unit of account that is e!%ected to a%%reciate i(a'ue

    +om%utation of themarket)s implied future spot rate)

    tFC

    HC1+t Si+1

    i+1=$-&S

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    E#pi!ic l e&i'ence( on IFE

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    E#pi!ic l e&i'ence( on IFE

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    The Fo!$ !' R te 5n;i (e' P!ope!t"

    Fo""o#s direct"$ fro &RP and &FE'

    % For#ard pre i( = % E)pected E)c*ange RateC*angeForward rate is an unbiased predictor of the futurespot rate ⇔ for#ard rates and interest di+erentia"sneit*er s$ste atica""$ o,er- and (nderesti ate t*e

    f(t(re spot rate

    t

    t1+t

    t

    t1+tt.

    SS)E(S

    =S

    SF --

    $&SFS

    S-$&Si1i1

    =S

    F1t1tt'

    t

    t1+t

    FC

    HC

    t

    1tt'++

    +=⇒=

    +

    +

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    E#pi!ic l e&i'ence( on Fo!$ !' ! te un;i (e'p!ope!t"

    m%irica' tests genera''y show that the forward rate isnot a good %redictorof the 'e(e' of the future s%ot rate

    =owe(er, there is strong e(idence that the forward rate does a $etter

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    Co#;inin, the p !it" !el tion(

    *6 1.32"6 +=F #*9

    F6,3&6 1.3"6G +=F #*9 π

    +=F 4? %aEπ #*9 2? %a π +=F @π #*9 2?

    i+=F "? %aE i+=F 3? %a i+=F i#*9 2?

    Forward %remium on #*9

    Forecast change in the s%ot rate

    224

    S

    SF

    0

    00' !0 =−≈−

    $a%%re"iatetoe/%e"te5&USD224S

    SS

    0

    0+!0 +=−≈−

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    Inte!n tion l p !it" !el tion( in e/uili;!iu#Forecast change in spot

    exchange rate

    +2%(USD strengthens)

    Forecast premium onforeign currency

    +2%

    Difference in nominalinterest rates

    +2%(higher in Switzerland)

    Forecast difference inrates of inflation

    +2%(higher in Switzerland)

    nterest rate parity(2)

    Forward rate un!iasedproperty

    (")

    nternational Fisher#ffect

    ($)

    Fisher closed( )

    &urchasing &ower&arity

    (')