Transcript Topics in Exchange Rates & Interest Rates

Topics in Exchange Rates &
Interest Rates
Saving
It is January 1st, and you have RMB1 to
save for 1 year. You can put it into:
1. Put it into a domestic currency bank
account at an interest rate i.
2. a foreign currency bank account at
interest rate iF.
Payoff to strategy #2
• Strategy two has three parts.
1. Buy foreign exchange at spot rate St to get {1/
St} US dollars.
2. Put {1/St } into bank account. After 1 year get
US$(1+iF)×{1/St }
3. Convert these funds into RMB at exchange
rate prevailing in 1 year.
(1  i F )  St 1
St
 HK $1000
Uncovered Interest Parity
• If
(1  i F )  St 1
St
> 1+i, deposit funds
then deposit in US$ account.
• If
(1  i F )  St 1 < 1+i, deposit funds
St
then deposit in HK$ account.
• Then in equilibrium
(1  i
F
St 1

)
1  i
St
Interest Rate Parity
• The only reason people would be willing to
hold a US$ account when US interest rates
were lower than domestic interest rate
would be if they can achieve an expected
gain from an increase in the value of US$
during the time that they were holding the
account.
St 1  St
• Approximately
F
ii 
St
Apr-04
Apr-03
Apr-02
Apr-01
Apr-00
Apr-99
Apr-98
Apr-97
Apr-96
Apr-95
Apr-94
Apr-93
Apr-92
International Interest Rates
14
12
10
8
India
6
Hong Kong
4
2
0
Ap
r- 0
4
Ap
r- 0
3
Ap
r- 0
2
Ap
r- 0
1
Ap
r- 0
0
Ap
r- 9
9
Ap
r- 9
8
Ap
r- 9
7
Ap
r- 9
6
Ap
r- 9
5
Ap
r- 9
4
Ap
r- 9
3
Ap
r- 9
2
Exchange Rate Appreciation
Rupees per HK$
7
6
5
4
3
2
1
0
Thai Interest Rates and the
Dollar/Baht Rate
.32
.28
.24
.20
16
.16
12
.12
8
4
0
1990
1992
1994
1996
1998
2000
HK$: Baht
Thai Baht Time Deposit Rate - 1Year
HK$ Time Deposits - 1 year
Covered Interest Parity
•
An investor has $1 for saving. Consider two
investment strategies:
1. Invest RMB1 in a domestic bond with interest rate
1+i.
2. Use RMB1 to buy 1/St foreign dollars in spot
markets. Invest 1/St in foreign bonds at interest rate
1+i*. Agree on a forward contract to sell (1+i*)/St
foreign currency for Ft (1  i* ) domestic dollars.
St
t
Arbitrage implies that the two strategies will have the
same pay-off. 1  i  Ft (1  i* )
t
•
St
t
This implies a forward price.
Ft  St 
1  it
1  it*
Fixed Exchange Rate
• If the central bank undertakes to keep the
exchange rate fixed and that is a credible
undertaking, then   0.
t 1
• If the relative values of currency are fixed,
then funds will flow out of the domestic
currency if domestic interest rates are too
low and flow into domestic currency if
interest rates are too high.
i = iF
Fed Funds
HIBOR
Jun-04
Jun-03
Jun-02
Jun-01
Jun-00
Jun-99
Jun-98
Jun-97
Jun-96
Jun-95
Jun-94
Jun-93
Jun-92
Jun-91
Jun-90
Jun-89
Jun-88
Jun-87
Jun-86
%
HIBOR vs. Fed Funds Rate
Interbank Rates
20
18
16
14
12
10
8
6
4
2
0
Costs & Benefits of Fixed
Exchange Rates
• Benefits
– Stable currency for international trade &
finance
• Costs
– Cannot adjust interest rates for domestic
stabilization of business cycles.
Managed Floating
• Most developed/OECD central banks set
domestic interest rates in response to domestic
price levels.
• Many emerging markets or developing
economies either set a fixed exchange rate or
simply use the currency of another country –
“Dollarization”
• Many other emerging markets also practice
“managed floating” which sometimes adjusts the
interest rate in response to domestic conditions
and sometimes intervenes in foreign currency
markets to stabilize the price level.
IMF Exchange Rate Classification
60
50
40
30
20
10
0
No Currency
Currency
Board
Fixed
Exchange
Rate
Band
Crawling
Peg
Managed
Float
Source http://www.imf.org/external/np/mfd/er/2005/eng/1205.htm
Free Float
Devaluation/Revaluation
• Even economies with fixed exchange rates
adjust these levels overtime.
• An increase in the price of US$ by a fixed
exchange rate regime is a devaluation.
• A decrease in the price of US$ is a
revaluation
Real Exchange Rate
• A country’s real exchange rate is the relative cost
of that country’s good when compared to foreign
goods when measured in domestic currency
PtUS
St
REX t  St  HOME 
Pt
PPPt
• Numerator: # of domestic currency units
needed to by the # of foreign currency units
needed to buy 1 foreign good.
• Denominator: # of domestic currency units
needed to buy
Purchasing Power Parity
• An currency achieves a PPP exchange
rate when the cost of purchasing foreign
goods equals domestic goods S = PPP,
REX = 1.
Does PPP Hold?
• Does Absolute or Relative PPP hold?
• In short run, NO. Exchange rates are much more
volatile than inflation rates.
• In long run for countries with similar levels of
development, PPP holds.
– Example. Twenty year averages for OECD countries.
Over-valued/Under-valued
• When the cost of purchasing foreign
goods is
– relatively high, S > PPP and a currency is said
to be undervalued.
– relatively low, S < PPP and a currency is said
to be overvalued.
Calculate Real Exchange Rate
• Calculate PPPt
– Get PPPReference from World Bank, U Penn etc.
– Convert CPI to World Bank Reference Year
Dollars for Domestic and Foreign Economy
CPI
CPIt
Gross Inflation Since Reference Year 
CPI Reference
Gross Inflation Since Reference Year HOME
PPPt  PPPReference 
Gross Inflation Since Reference Year Foreign
Example
• Germany: PPP in
2002 was .9 meaning
goods that cost $1 in
the US cost €.90 in
Germany.
• But prices (and
exchange rates) have
changed since then.
2002
2006
CPIUSA
104.5
117.1
CPIGermany
103.3
110.2
S2006
.8
Problem
• What is the exchange rate at which Euro is
neither under nor overvalued in 2006?
• What is gross inflation in Germany?
• What is gross inflation in USA?
• What is PPP in 2006?
Relative PPP
• In the long-run, we expect prices to
converge through arbitrage trade (i.e.
exporters should ship goods from a cheap
market to an expensive one, until prices
equalize across markets).
• The average growth rate of the exchange
rate should be equal to the inflation
differentials.
S
HOME
US $
gt   t
 t
Long Run: Developed Economies
Source: IFS 1975-1995
PORTUGAL
ITALY
SPAIN
SWEDEN
UNITED KINGDOM
AUSTRALIA
FRANCE
CANADA
BELGIUM
GERMANY
NETHERLANDS
JAPAN
-4.00%
-2.00%
0.00%
Inflation Differential
2.00%
4.00%
Exchange Rate Depreciation
6.00%
8.00%
Learning Outcome
• Use the theory of Uncovered interest
parity to predict exchange rate movements
with domestic and foreign interest rates.
• Use the theory of covered interest parity to
estimate the future price of currency.
• Use the theory of purchasing power parity
to suggest whether a currency is
undervalued or over-valued.