Transcript Chapter 5

International Financial Markets
Prices and Policies
Second Edition ©2001
Richard M. Levich
5

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International Parity Conditions:
Interest Rate and the Fisher Parities
5-2
Overview
 The Usefulness of the Parity Conditions in
International Financial markets: A Reprise
 Interest Rate Parity: The Relationship between
Interest Rates, Spot Rates, and Forward Rates
Interest Rate Parity in a Perfect Capital Market
 Relaxing the Perfect Capital Market Assumptions
 Empirical Evidence on Interest Rate Parity

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5-3
Overview
 The Fisher Parities
The Fisher Effect
 The International Fisher Effect
 Relaxing the Perfect Capital Market Assumptions
 Empirical Evidence on the International Fisher
Effect

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5-4
Overview
 The Forward Rate Unbiased Condition
Interpreting a Forward Rate Bias
 Empirical Evidence on the Forward Rate Unbiased
Condition
 Tests Using the Level of Spot and Forward
Exchange Rates
 Tests Using Forward Premiums and Exchange Rate
Changes

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5-5
Overview
 Policy Matters - Private Enterprises
Application 1: Interest Rate Parity and One-Way
Arbitrage
 Application 2: Credit Risk and Forward Contracts To Buy or to Make?
 Application 3: Interest Rate Parity and the Country
Risk Premium
 Application 4: Are Deviations from the
International Fisher Effect Predictable?

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5-6
Overview
Application 5: Are Deviations from the
International Fisher Effect Excessive?
 Application 6: International Fisher Effect and
Diversification Possibilities
 Application 7: International Fisher Effect, LongTerm Bonds, and Exchange Rate Predictions

 Policy Matters - Public Policymakers
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The Usefulness of the Parity Conditions in
International Financial Markets: A Reprise
5-7
 Compared to PPP, violations in the other parity
conditions may present more immediate profit
opportunities because the cost of entering into
financial transactions is typically less than in
goods markets.
 If a parity financial condition is violated, an
opportunity for profit may be present.
 Note however that financial markets are often
subject to controls and taxes.
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Interest Rate Parity: The Relationship between
Interest Rates, Spot Rates, and Forward Rates
5-8
Interest Rate Parity (IRP)
The forward exchange rate premium equals
(approximately) the U.S. interest rate minus the foreign
interest rate.
F  S  S  i$  i£
Driven by arbitrage between the spot and forward
exchange rates, and money market interest rates.
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Interest Rate Parity
5-9
in a Perfect Capital Market
 IRP draws on the principle that in equilibrium,
two investments exposed to the same risks must
have the same returns.
 Suppose an investor puts $1 in a US$ security.
At the end of one period, wealth = $1  (1 + i$)
 Alternatively, the investor can put the $1 in a
UK£ security and cover his or her exposure to
UK£ exchange rate changes. At the end of one
period, wealth = $1 1.0  1  i  F
£
t ,1
St
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Interest Rate Parity
5 - 10
in a Perfect Capital Market
 Driven by covered interest arbitrage, the two
investments should produce identical ending
wealth. So,
1.0
$1
 1  i£  Ft ,1  $1 1  i$ 
St

Ft ,1  St
St
i$  i£

1  i£
% forward premium = % interest differential
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Interest Rate Parity
5 - 11
in a Perfect Capital Market
 The term (F–S)/S is called the forward
premium. When (F–S)/S < 0, the term forward
discount is often used.
 When the forward premium or discount is
plotted against the interest rate differential, the
45° line represents the interest rate parity line.
 The IRP line represents the dividing line
between investments in the domestic security
and investments in the foreign security that
have been covered against exchange risk.
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5 - 12
The Interest Rate Parity Line
Equilibrium and Disequilibrium Points
Forward Premium: (F– S ) / S
0.04
0.03
0.02
0.01
Capital Outflows
$ to Foreign Currency
A’
B’
B
0
- 0.01
- 0.02
A
B”
A”
Capital Inflows
Foreign Currency to $
- 0.03
- 0.04
- 0.04 - 0.03 - 0.02 - 0.01
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0
0.01
0.02
(i$ – iforeign) / (1 + iforeign)
0.03
0.04
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Relaxing the
5 - 13
Perfect Capital Market Assumptions
Forward Premium
 Transaction costs has the effect of creating a
“neutral band” within which covered interest
arbitrage transactions will not occur.
neutral band
Interest Differential
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Relaxing the
5 - 14
Perfect Capital Market Assumptions
 Differential capital gains and ordinary income
tax rates can tilt the 45° slope of the IRP line.

However, the actual impact depends on the exact
tax rates, the number of people who are subject to
those rates, and transactions costs which may
dominate the role of taxes.
 There are also uncertainty risks.
Placing orders takes time and market prices may
change.
 The foreign investment may present country risks.

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5 - 15
Empirical Evidence on Interest Rate Parity
 The Eurocurrency markets made it possible to
examine two securities that differed only in
terms of their currency of denomination.
 The general result is that IRP holds in the shortterm Eurocurrency market after accounting for
transaction costs.
 For longer-term securities, a study found
significant deviations from parity that represent
profit opportunities even after adjusting for
transaction costs.
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5 - 16
The Fisher Parities
Fisher Effect (Fisher Closed)
For a single economy, the nominal interest rate equals the
real interest rate plus the expected rate of inflation.

~
i$  r$  E PUS

Driven by desire to insulate the real interest against
expected inflation,
and arbitrage between real and nominal assets.
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5 - 17
The Fisher Effect
 The Fisher effect represents arbitrage between
real assets and nominal (or financial) assets
within a single economy.
 At the end of one period, a $1 commodity
~
holding can be liquidated for $1[1+E(p)],
where
~
E(p) is the expected rate of inflation.
 To be indifferent, an interest-bearing security
will need an end-of-period value of
~
$1(1+r)[1+E(p)],
or $1(1+i).
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5 - 18
The Fisher Effect
~
 So,

(1+i) = (1+r)[1+E(p)]
~
~
i = r + E(p)
+ r E(p)
 Where inflation and the real interest rate are
low, the Fisher effect is usually approximated
as:
~
i = r + E(p)
% nominal
% real
% expected
interest rate = interest rate + inflation
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5 - 19
The Fisher Parities
International Fisher Effect (Fisher Open)
or uncovered interest parity
For two economies, the U.S. interest rate minus the
foreign interest rate equals the expected percentage
change in the exchange rate.

~
i$  i£  E Spot

Driven by arbitrage in bonds denominated
in two currencies.
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5 - 20
The International Fisher Effect
 Interest rates across countries must also be set
with an eye toward expected exchange rate
changes.
 Suppose an investor puts $1 in a US$ security.
At the end of one period, wealth = $1  (1 + i$)
 Alternatively, the investor can put the $1 in a
UK£ security. At the end of one period, wealth
1.0
~
 $1
 1  i£  E St 1
St
 
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5 - 21
The International Fisher Effect
 Under PCM assumptions, the ending wealth
should be identical:
1.0
~
$1 1  i$   $1
 1  i£  E St 1
St
 

 
~
E St 1  St i$  i£

St
1  i£
% expected
exchange rate change = % interest differential
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5 - 22
The International Fisher Effect
 The market’s implied future spot rate :

1  i$ 
~
E St 1 
 St
1  i£ 
 So, the market expects the US$ to appreciate
when US$ interest rates are lower than foreign
interest rates, and vice versa.
 Note that the International Fisher Effect
implicitly assumes that real interest rates are
equal across countries.
 
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Relaxing the
5 - 23
Perfect Capital Market Assumptions
 Transaction costs result in a neutral band
around the parity line, while differential taxes
can possibly tilt the parity line.
 Since the ending value of the foreign
investment depends on an uncertain future spot
rate, an exchange-risk premium may be
required.
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Empirical Evidence on
5 - 24
the International Fisher Effect
 Empirical tests indicate that the International
Fisher Effect condition performs poorly in
individual periods.
 However, over extended periods of time, it
appears that currencies with high interest rates
tend to depreciate, and vice versa, as predicted.
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5 - 25
The Forward Rate Unbiased Condition
Forward Rate Unbiased
Today’s forward premium (for delivery in n days)
equals the expected percentage change in the spot rate
(over the next n days).
Ft  St 
  
~
St  E St n  St St
Driving force: Market players monitor the difference
between today’s forward rate (for delivery in n days)
and their expectation of the future spot rate
(n days from today).
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5 - 26
The Forward Rate Unbiased Condition
 From IRP and the International Fisher Effect:
~
E St 1  St Ft ,1  St

St
St
% expected
exchange rate change = % forward premium
 
 If the average deviation between today’s Ft,1
and the actual future St+1 is small and near
zero, then the forward rate is an unbiased
predictor of the future spot rate.
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5 - 27
The Forward Rate Unbiased Condition
 A forward rate bias may imply market
inefficiency, or it may reflect a risk premium.
 Empirical data reveals that the forward rate and
future spot rate track along a very similar path,
though F tracks “below” the future S when the
spot rate is rising, and vice versa.
 On the other hand, actual exchange rate
changes form a volatile series, while the
forward premium is relatively smooth and calm.
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5 - 28
Policy Matters - Private Enterprises
 Managers may make profit maximizing
decisions by exploiting deviations from the
parity conditions, or they may want to avoid or
hedge the risks of such deviations.
 Application 1: IRP & One-Way Arbitrage

One-way arbitrage is picking the better-priced
alternative for a transaction in the presence of
transaction costs.
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5 - 29
Example of One-Way Arbitrage
A manager who holds US$ now wants € in the future.
currency dimension
Jan 1
US$
B
time dimension
Invest US$ at i$
Jul 1
A
Path 1
By taking the lower cost
path, the manager is
engaging in one-way
arbitrage.
Buy €
spot at S
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Buy €
forward
at F
Path 2
€
C
Invest € at i€
D
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5 - 30
Policy Matters - Private Enterprises
 Application 2: Credit Risk & Forward Contracts

The costs of using an outright forward versus a
synthetic forward for hedging may differ for firms
because credit risk is usually priced in bank loans
but not in forward contracts.
 Application 3: IRP & the Country Risk Premium

The deviations of government securities from IRP
provides a measure of the political risk differences
among countries.
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5 - 31
Policy Matters - Private Enterprises
 Appln 4: Are Deviations from IFE Predictable?

Even if the deviations are zero on average, a
nonrandom pattern can present a profit opportunity.
 Appln 5: Are Deviations from IFE Excessive?
Under a system of pegged exchange rates, any
interest rate differential represents a deviation.
 A speculator may (1) invest in the high i currency
when the peg is expected to hold, or (2) borrow the
high i currency when the peg is expected to change
by more than the interest differential.

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5 - 32
Policy Matters - Private Enterprises
 Appln 6: IFE and Diversification Possibilities

Can passive investors gain by holding a diversified
portfolio of international currencies on an unhedged
basis?
 Appln 7: IFE, Long-Term Bonds & Exchange
Rate Predictions

When IFE is extended to long-term bonds (n-period
investments) :
n

1  i$, n 
~
E St  n 
 St
n
1  i£,n 
 
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5 - 33
Policy Matters - Public Policymakers
 The Fisher parities can provide information
regarding how closely national financial
markets are linked to one another, and what
price, if any, a nation is paying for perceived
political and economic risks.
 The interest rate differential may be a useful
indicator of policy credibility for countries
following pegged exchange rate policies.
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