FIN 40500 International Finance Interest Rate Parity Spot

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FIN 40500: International Finance Interest Rate Parity

FIN 40500: International Finance Interest Rate Parity

Spot market volume is small relative to total currency volume Forward contracts refer to

Spot market volume is small relative to total currency volume Forward contracts refer to contracts that define a currency transaction at some future date (usually 30, 90, 180, or 360 days) EUR/USD 1 month 3 months 6 months 12 months 1. 2762 1. 2786 1. 2836 1. 2905 1. 3026

EUR/USD 1 month 3 months 6 months Forward Price 1. 2762 1. 2786 1.

EUR/USD 1 month 3 months 6 months Forward Price 1. 2762 1. 2786 1. 2836 1. 2905 Forward rates are often expressed as (annualized) percentage differences from the current spot rate – called the forward premium/discount Spot Price Days until expiration The 30 Day EUR is selling at a premium of 2. 26% EUR/USD 1 month 3 months 6 months --2. 26% 2. 32% 2. 22%

Forwards/Futures can be used to eliminate the risk involved in international transactions Porsche expects

Forwards/Futures can be used to eliminate the risk involved in international transactions Porsche expects $10 M in US sales over the next month that it would like to repatriate back to Germany Mercedes need to acquire $10 M to meet its payroll for its Tuscaloosa, Alabama plant Porsche is worried that the dollar might depreciate over the next month Mercedes is worried that the dollar might appreciate over the next month Both of these companies could benefit from “locking in” their conversion rate.

The bank acts as the middleman in a forward contract Deutsche Bank Porsche approaches

The bank acts as the middleman in a forward contract Deutsche Bank Porsche approaches Deutsche Bank with an offer to buy Euro 30 days forward Deutsche Bank offers a price of 1. 2786 Dollars per Euro Mercedes approaches Deutsche Bank with an offer to sell Euro 30 days forward

On Settlement day, Porsche buys E 7. 821 M for $10 M (Porsche gains

On Settlement day, Porsche buys E 7. 821 M for $10 M (Porsche gains by E 92, 400) EUR/USD e = 1. 2939 Days On Settlement day, Mercedes buys $10 M for E 7. 821 M (Mercedes loses E 92, 400)

Futures are standardized, traded commodities (Chicago Mercantile Exchange) EUR 125, 000 Total Contracts bought/sold

Futures are standardized, traded commodities (Chicago Mercantile Exchange) EUR 125, 000 Total Contracts bought/sold that day (000 s) Opening, High, Low, and Closing Price Strike Open High Low Settle Pt Chge Volume Interest SEP 06 1. 2700 1. 2804 1. 2698 1. 2756 +170 3500 8993 OCT 06 1. 2850 1. 2987 1. 2800 1. 2799 -150 3 34 NOV 06 ------ Settlement Date ----- UNCH Change From Prior Day (in Pips) ----- Contracts Outstanding (000 s)

The exchange acts as the middleman in a futures contract Chicago Mercantile Exchange Porsche

The exchange acts as the middleman in a futures contract Chicago Mercantile Exchange Porsche goes long on 7 Euro contracts The CME simultaneously buys 7 contracts from Mercedes and sells 7 contracts to Porsche Why do we need a middleman? Mercedes goes short on 7 Euro contracts

Suppose that you observe the following information… Currency Markets EUR/USD 1 month 3 months

Suppose that you observe the following information… Currency Markets EUR/USD 1 month 3 months 6 months 1. 2762 1. 2786 1. 2836 1. 2905 Money Markets (Annualized Rates) LIBOR (Dollar Denominated) 1 month 5. 08 % 3 months 5. 21 % 6 months 5. 31 % Money Markets (annualized Rates) EURO LIBOR (Euro Denominated) 1 months 2. 82 % 3 months 3. 00 % 6 months 3. 09 % The Euro 1 month forward is selling at a 2. 26% (annualized) premium Hmmm…. the (annualized) difference between Dollar denominated loans and Euro denominated loans is also 2. 26% Is this just a crazy coincidence?

Now, try the 3 month yields Currency Markets EUR/USD 1 month 3 months 6

Now, try the 3 month yields Currency Markets EUR/USD 1 month 3 months 6 months 1. 2762 1. 2786 1. 2836 1. 2905 Money Markets (Annualized Rates) LIBOR (Dollar Denominated) 1 month 5. 08 % 3 months 5. 21 % 6 months 5. 31 % Money Markets (annualized Rates) EURO LIBOR (Euro Denominated) 1 months 2. 82 % 3 months 3. 00 % 6 months 3. 09 % The Euro 1 month forward is selling at a 2. 32% (annualized) premium Hmmm…. the (annualized) difference between Dollar denominated loans and Euro denominated loans is 2. 21% Can we profit off this information? ?

Consider the following investment strategy: Convert the $1 to Euros Borrow $1 in the

Consider the following investment strategy: Convert the $1 to Euros Borrow $1 in the US for 3 months This strategy yields a 3 month return of 3 basis points!!! RISK FREE!!! Invest the E. 7836 for 3 months Convert the proceeds back to dollars and repay your loan

Financial markets will adjust so that you can’t earn risk free profits – the

Financial markets will adjust so that you can’t earn risk free profits – the condition that insures this is called covered interest parity Dollar return on foreign bonds Dollar return on domestic bonds A useful approximation can be written as follows Interest Differential Forward Premium/Discount Note: this only holds if the two assets have the same risk characteristics

Convert to foreign currency at current spot rate Now, suppose that we tried a

Convert to foreign currency at current spot rate Now, suppose that we tried a similar strategy, but without using forward contracts. This strategy involves risk, and is, hence, called uncovered interest parity Borrow in the US Invest Abroad ? Convert to dollars at some future spot rate

Financial markets will adjust so that you can’t EXPECT to earn risk free profits

Financial markets will adjust so that you can’t EXPECT to earn risk free profits –this is called uncovered interest parity Expected spot rate change A useful approximation can be written as follows Expected appreciation/depreciation Interest Differential Note: this only holds if the two assets have the same risk characteristics

Euro interest rates rise Dollar interest rates rise LIBOR Euro LIBOR Dollar interest rates

Euro interest rates rise Dollar interest rates rise LIBOR Euro LIBOR Dollar interest rates rise

1/31: Euro trades at $1. 2158 2/28: Euro trades at $1. 1925 A 23%

1/31: Euro trades at $1. 2158 2/28: Euro trades at $1. 1925 A 23% (annualized) dollar appreciation? ? ? EUR/USD Interest Differential Throughout January, LIBOR is 2% above Euro LIBOR – the dollar should depreciate by 2% (annualized) over the upcoming month

Throughout February, LIBOR approaches 2% above Euro LIBOR – the dollar should depreciate by

Throughout February, LIBOR approaches 2% above Euro LIBOR – the dollar should depreciate by 2% (annualized) over the upcoming month A 24% (annualized) dollar depreciation 3/29: Euro trades at $1. 2139 3/1: Euro trades at $1. 1899

Throughout March, LIBOR rises to over 2% above Euro LIBOR – the dollar should

Throughout March, LIBOR rises to over 2% above Euro LIBOR – the dollar should depreciate by 2% (annualized) over the upcoming month A 48% (annualized) dollar depreciation!!! 4/29: Euro trades at $1. 2624 4/1: Euro trades at $1. 2124

Here, the dollar is going in the wrong direction (according to UIP) Now we’re

Here, the dollar is going in the wrong direction (according to UIP) Now we’re in the right direction, but by too much! (according to UIP)

Can futures markets actually predict the future? Covered Interest Parity Uncovered Interest Parity Combining

Can futures markets actually predict the future? Covered Interest Parity Uncovered Interest Parity Combining our two conditions tells us that if both CIP and UIP hold, then the Forward/Futures market should provide an unbiased predictor of the future spot exchange rate

We can test this hypothesis by running a linear regression of the following form

We can test this hypothesis by running a linear regression of the following form Previous Forward Premium/Discount Percentage change in exchange rate Error term The unbiased hypothesis would suggest that beta should equal one

It turns out that estimates of beta are routinely NEGATIVE!! This is known as

It turns out that estimates of beta are routinely NEGATIVE!! This is known as the Forward Premium Puzzle These results suggests that you could systematically make money by exploiting interest rate differentials!!

Lets take a closer look at the international parity conditions… Purchasing Power Parity (zero

Lets take a closer look at the international parity conditions… Purchasing Power Parity (zero arbitrage condition for trade in goods) 1 Uncovered Interest Parity (zero arbitrage condition for trade in assets) 2 Additionally, we need to recognize the Fischer effect 3 Nominal Interest Rate Expected Inflation Real Interest Rate What happens if we combine these conditions?

Lets take a closer look at the international parity conditions… Uncovered Interest Parity Purchasing

Lets take a closer look at the international parity conditions… Uncovered Interest Parity Purchasing Power Parity A little manipulation… Fischer Effect Real Returns are equalized across countries

We need to take a step back and recall where interest rates come from

We need to take a step back and recall where interest rates come from in the first place. For starters, assume a closed economy (i. e. no trade) Real (inflation adjusted) interest rate Household savings (supply of funds) Private capital investment plus government borrowing (demand for funds) Interest rates adjust to clear the domestic capital market

Suppose, for example, that the government increases its borrowing by $300 B. The rise

Suppose, for example, that the government increases its borrowing by $300 B. The rise in government borrowing increases the demand for loans Interest rates rise to clear the domestic capital market

Now, lets consider the US as part of a larger global community In the

Now, lets consider the US as part of a larger global community In the absence of trade, US interest rates are high (due to excessive borrowing) while interest rates in Japan are low (due to excessive savings)

Now, allow the two countries to interact in international capital markets. Available savings from

Now, allow the two countries to interact in international capital markets. Available savings from Japan flows to the US for a higher return With integrated capital markets, real return are equalized between the US and Japan. The US runs a trade deficit (net global borrower) while Japan runs a trade surplus (net global lender)

Actually, the US and Japan are only two of many countries in a global

Actually, the US and Japan are only two of many countries in a global capital market. This global capital market aggregates savings and borrowing across the globe and determines a common global real interest rate $20 Some countries run surpluses But global trade is balanced! Some countries run deficits

With a globally integrated capital market, no country (even the US can have a

With a globally integrated capital market, no country (even the US can have a significant impact on global returns. Hence, real interest rates are constant Suppose that savings in the US declines. Rather than raising interest rates, the US trade balance worsens

Back to our international parity conditions… Purchasing Power Parity (zero arbitrage condition for trade

Back to our international parity conditions… Purchasing Power Parity (zero arbitrage condition for trade in goods) 1 Uncovered Interest Parity (zero arbitrage condition for trade in assets) 2 These conditions represent two fundamental principles… 1) Global capital markets are equating international real rates of return. 2) Nominal variables are being scaled consistently to account for inflation (PPP for exchange rates and the Fischer Effect for Interest rates)

However, there are some more subtle reasons for the failure of uncovered interest parity

However, there are some more subtle reasons for the failure of uncovered interest parity Suppose that PPP fails (for any one of the many reasons discussed earlier). Then changes in the nominal exchange rate have three components Some relative price effect Now, plug this into the UIP condition and use the Fischer relation as we did before… Even with fully integrated capital markets, there should be a gap between international rates of return based on real exchange rate movements

A second problem is that UIP involves (through the Fischer effect) EXPECTATIONS of inflation…we

A second problem is that UIP involves (through the Fischer effect) EXPECTATIONS of inflation…we can’t really measure these Uncovered Interest Parity Fischer Relationship Suppose that individuals make forecast errors…then we can re-write the above expression Observable Un-observable forecast errors

Suppose that individuals make forecast errors…then we can re-write the above expression As long

Suppose that individuals make forecast errors…then we can re-write the above expression As long as people are not making systematic mistakes, then these error terms will be mean zero and will essentially disappear. However, if they are not mean zero… So, do individuals make systematic errors in their inflation forecasts?

Negative real returns in the 70’s suggest that individuals were making systematic mistakes for

Negative real returns in the 70’s suggest that individuals were making systematic mistakes for over ten years!! US Interest Rates Expectation Errors