Chapter 15 Exchange Rates Interest Rates and Interest

Topics to be Covered • Interest Rate Parity • Nominal Interest Rate • Real

Interest Parity • The interest parity relationship is a result of profit-seeking arbitrage activity

Interest Parity (cont. ) • By investing $1 at home, the U. S. investor

Covered Return • Covered return is the domestic currency value of a foreign investment

Interest Rate Parity • Interest rate parity states that the forward premium (or discount)

Effective Return • The effective return on a foreign investment is given by the

Reasons Why Interest Rate Parity May Not Hold • Buying and selling foreign exchange

Interest Rates and Inflation • Nominal Interest Rate—the interest rate actually observed in the

Fisher Equation • The relationship between interest rates and inflation is given by the

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Exchange Rates, Interest Rates, and Inflation • Real interest rates are equalized across countries

Term Structure of Interest Rates • There is no such thing as the interest

Expected Exchange Rates and Term Structure of Interest Rates • Refer to Figure 15.

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Chapter 15 Exchange Rates, Interest Rates, and Interest Parity

Topics to be Covered • Interest Rate Parity • Nominal Interest Rate • Real Interest Rate • Fisher Equation • Exchange Rates, Interest Rates, and Inflation • Expected Exchange Rates and the Term Structure of Interest Rates Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 2

Interest Parity • The interest parity relationship is a result of profit-seeking arbitrage activity called covered interest arbitrage. • A U. S. investor deciding between investing in the U. S. or in the U. K. must consider: The interest rates, i$ and i£ The spot exchange rate, E , (in $/ £) The forward exchange rate, F, (in $/ £) Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 3

Interest Parity (cont. ) • By investing $1 at home, the U. S. investor can earn 1 + i$ for one period. • Or, since $1 = 1/E pounds, the U. S. investor can invest in the U. K. and earn (1 + i£)/E. • Since future spot rates are unknown, the investor can eliminate the uncertainty over the future dollar value of the investment with a forward exchange contract. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 4

Covered Return • Covered return is the domestic currency value of a foreign investment when the foreign currency proceeds are sold in the forward market. • In our example, the covered return is equal to (1 + i£)F/E dollars. Arbitrage between the two investment opportunities results in: Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 5

Interest Rate Parity • Interest rate parity states that the forward premium (or discount) is equal to the interest differential. This parity is approximated by the equation: Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 6

Effective Return • The effective return on a foreign investment is given by the interest rate plus the expected change in the exchange rate. • Using our example, the effective return is: Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 7

Reasons Why Interest Rate Parity May Not Hold • Buying and selling foreign exchange and international securities involve transaction costs. • Taxes may differ according to an investor’s residence. • Government controls on financial capital flows may exist. • There may be political risks. • There are time lags between observing the profit opportunity and actually trading to realize the profit. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 8

Interest Rates and Inflation • Nominal Interest Rate—the interest rate actually observed in the market. • Real Interest Rate—the nominal interest rate minus or adjusted for inflation. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 9

Fisher Equation • The relationship between interest rates and inflation is given by the Fisher equation: where i is the nominal interest rate, r is the real interest rate, and π is the expected rate of inflation. • Refer to Table 15. 1 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 10

Exchange Rates, Interest Rates, and Inflation • Real interest rates are equalized across countries when the Fisher equation, interest rate parity, and relative purchasing power parity all hold. • Given our U. S. and U. K. investment example: • Interest rates, inflationary expectations, and exchange rates are all jointly determined and affected by government policy changes and other news. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 12

Term Structure of Interest Rates • There is no such thing as the interest rate for a country. • Term structure of interest rates—the pattern of interest rates over different terms of maturity. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 13

Expected Exchange Rates and Term Structure of Interest Rates • Refer to Figure 15. 1 Eurocurrency Interest Rates • If the term structure lines for two countries are: Parallel, then exchange rate changes are expected to be constant Diverging, then the high-interest-rate currency is expected to depreciate at an increasing rate over time Converging, then the high-interest-rate currency is expected to depreciate at a declining rate relative to the low-interest-rate currency Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 14