Transcript Chapter 5
International Financial Markets Prices and Policies Second Edition ©2001 Richard M. Levich 5 McGraw Hill / Irwin 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 McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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 McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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 McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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? McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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 McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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 McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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 McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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 McGraw Hill / Irwin 0 0.01 0.02 (i$ – iforeign) / (1 + iforeign) 0.03 0.04 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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 McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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 $1(1+i). McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5 - 18 The Fisher Effect ~ So, (1+i) = (1+r)[1+E(p)] ~ ~ i = r + E(p) + r E(p) Where inflation and the real interest rate are low, the Fisher effect is usually approximated as: ~ i = r + E(p) % nominal % real % expected interest rate = interest rate + inflation McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5 - 19 The Fisher Parities International Fisher Effect (Fisher Open) or uncovered interest parity For two economies, the U.S. interest rate minus the foreign interest rate equals the expected percentage change in the exchange rate. ~ i$ i£ E Spot Driven by arbitrage in bonds denominated in two currencies. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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 McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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 McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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). McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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 McGraw Hill / Irwin Buy € forward at F Path 2 € C Invest € at i€ D 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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 McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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. McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.