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Dubai

International Finance And Financial Institutions-04

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Published in: Economics | Finance
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Relationship between the Exchange Rate and Other Macroeconomic Variables

Namal I / Dubai

10 years of teaching experience

Qualification: BA(Economics)Special (Hons)(2nd Class). MA(Economics), MA(Financial Economics),M.Econ, MBA, PGD in Information Technology, MIT-Master of Information Technology, NVQ Level 4: Diploma in Computer Networking.

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  1. Online Version International Finance and Financial Institutions Relationship between the Exchange Rate and Other Macroeconomic Variables - IV
  2. Readings Shapiro Chapter 4: International Finance and Currency: Parity Conditions Eun and Resnick Chapter 5: International Parity Relationships and Forecasting Foreign Exchange Rates Online Version
  3. • The Fisher Effect Interest rates quoted in the financial press are nominal rates: rate of exchange between current and future money Real interest rates do matter: — Rate at which current goods are being converted into future goods Net increase in wealth expected to achieve when current income is saved and invested Real interest rate must adjust to reflect expected inflation Fisher Effect describes the relationship between inflation and both real and nominal interest rates Online Version 3
  4. The Fisher Effect Equilibrium interest rate responds to an increase in expected inflation FIGURE 4 Response to a Change in Expected Inflation When expected inflation rises, the supply curve shifts from to m, and the demand curve shifts from to The equilibrium moves from point 1 to point 2, causing the equi- librium bond price to fall from PI to P2 and the equilibrium interest rate to rise. Online Version price of Bonds. p Step 3. causing the prte Of to fall and the equilibrium interest rate to rise. BS2 2 Quantty of Bonds, B 2 _ an:' shifts the bond supply Curve St4) 1. A rise in expected Inflation shifts the bond demand curve
  5. The Fisher Effect Inflation must be kept low if we want to keep nominal interest rates low Annual Rate (%) Expected Inflation Interest Rate 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 FIGURE 5 Expected Inflation and Interest Rates (Three-Month Treasury Bills), 1953—2014 The interest rate on three-month Treasury bills and the expected inflation rate generally move together, as the effect predicts. Online Version 5
  6. Reading Indicators Si - IMIatim * 15 — CPI Irtlatian Online Version — T-bill Fue (340tt-0 6
  7. The Fisher Effect Fisher effect suggests that the nominal interest rate r is made up of two components: — a real required rate of return a — an inflation premium equal to the expected amount of inflation i I + Nominal rate = (l + Real rate)(l + Expected inflation rate) Online Version
  8. The Fisher Effect The generalized version of the Fisher effect asserts that real returns are equalized across countries through arbitrage: ah = where subscripts h and f refer to home and foreign real rates, respectively. If expected real returns were higher in one currency than another, capital would flow from the second to the first currency This process of arbitrage would continue (in the absence of government intervention) until expected real returns were equalized Online Version
  9. The Fisher Effect • In equilibrium, nominal interest rate differential will approximately equal the anticipated inflation differential between two currencies (with no government interference): — rh and rfare the nominal home and foreign currency interest rates • Exact relationship can be termed as: Online Version
  10. The Fisher Effect • • Currencies with high rates of inflation should bear higher interest rates than currencies with lower rates of inflation Parity line: = ih i Online Version Interest differential, in favor of home country (%) —5 -3 -2 5 4 3 2 —2 —4 Parity line 2 Inflation differential, home country relative to foreign country (%) 10
  11. The Fisher Effect Empirical evidence: — Most of the variation in nominal interest rates across countries can be attributed to differences in inflationary expectations Regression ine PakS% Inomgsia Huuar/ Austraa Israel Online Version Inflation rate as the change in the CPI over the past 12 rnonttE) 11
  12. The Fisher Effect • Empirical evidence: — Koustasa and Serletis (JME, 1999) - rejecting the Fisher effect for a sample of advanced countries — Coppock and Poitras (IREF, 2000) - interest rates for a sample of advanced and emerging countries fail to fully adjust to inflation due to variation in the implicit liquidity premium on financial assets — Cooray (SAEJ, 2002) - some support is found for the Fisher relationship in Sri Lanka Online Version 12
  13. The Fisher Effect The proposition that expected real returns are equal between countries cannot be tested directly • However, significant real interest differentials cannot persist due to increasingly internationalized capital markets Arbitrage is forcing real interest rates to converge across all the major nations Capital markets are integrated worldwide through the arbitrage Online Version
  14. The Fisher Effect Capital market integration - real interest rates are determined by the global supply and global demand for funds Capital market segmentation - real interest rates are • determined by local credit conditions Dus 2 aus sus Credit (a) Capital Market Segmentation 2 anv sw=s + s Credit (b) Capital Market Integration In an integrated capital market, the domestic real interest rate depends on what is happening outside as well as inside the country
  15. The Fisher Effect Once markets open up, domestic real interest rate adjusts to the world rates, determined by: — world supply for credit sw (Sus+Snv) — world demand for credit Du, (Dus+Drw) Interest rates adjust througn capital flows • Capital market integration has homogenized markets around the world • If real interest differentials do exist, they are due to either currency risk or some form of political risk — Estimated currency risk premium appears to be highly variable and unpredictable, leading to real interest rate differential between nations Online Version 15
  16. The Fisher Effect Countries with higher nominal interest rates (implying higher expected inflation and greater currency risk) tend to have higher real interest rates Real interest rate differentials can stem from differing tax policies or imposing regulatory barriers to the free flow of capital Online Version REAL INTEREST RATE VERSUS NOMINAL INTEREST RATE 2B DEVELOPED ANO DEVELOPING COUNTRIES AS OF MAY 2007 if 16
  17. International Fisher Effect International Fisher Effect (IFE): expected disparity between the exchange rate of two currencies is approximately equal to the difference between their countries' nominal interest rate • IFE combines implications of PPP and the Fisher effect — PPP implies that exchange rates will move to offset changes in inflation rate differentials — A rise in the inflation in HC relative to those of other countries is associated with a fall in the HC currency value — It will also be associated with a rise in the HC interest rate relative to foreign interest rates Online Version 17
  18. International Fisher Effect Differences in nominal interest rates reflect expected changes in the spot exchange rate between countries: (1 + rpt — where is the expected exchange rate in period t • If rf is relatively small, the approximation to the IFE: Online Version 18
  19. International Fisher Effect Implication of IFE: — Currencies with low interest rates are expected to appreciate relative to currencies with high interest rates — Arbitrage between financial markets (international capital flows) should ensure that interest differential between any two countries is an unbiased predictor of the future change in the spot rate of exchange Online Version Expected change in 5 home currency value Of foreign currency (%) 4 3 2 _5 _4 -3 -2 parity line 2345 Interest differential in favor Of home country (%) 19
  20. International Fisher Effect Empirical Evidence — IFE hold even in the short run in the case of nations facing very rapid rates of inflation — Evidence to indicate that the IFE does not hold up very well in the short run for nations with low to moderate rates of inflation — Alizadeh et al. (JAS, 2014) - exchange rates movements do not follow the International Fisher Effect theory and nominal interest rate differentials cannot completely offset the currency value changes among ASEAN countries in the long run Online Version 20
  21. Interest Rate Parity (IRP) Spot and forward rates are closely linked to each other and to interest rates in different currencies through arbitrage Movement of funds between two currencies to take advantage of interest rate differentials — a major determinant of the spread between forward and spot rates • Forward discount or premium is closely related to interest differential between the two currencies Online Version
  22. • Interest Rate Parity (IRP) Theory Interest Rate Parity (IRP) Theory: — Currency of the country with a lower interest rate should be at a forward premium in terms of the currency of the country with the higher rate In an efficient market with no transaction costs, the interest differential should be (approximately) equal to the forward differential When this condition is met, the forward rate is said to be at interest rate parity - equilibrium prevails in money markets — Domestic interest rate equals the foreign interest rate minus the expected appreciation of the domestic currency Online Version 22
  23. Interest Rate Parity (IRP) Theory • Interest parity ensures that the return on a hedged (or "covered") foreign investment will just equal the domestic interest rate on investments of identical risk When this condition holds, the covered interest differential (difference between the domestic interest rate and the hedged foreign rate) is zero Online Version 23
  24. Interest Rate Parity (IRP) Theory Regardless of the investor's currency choice, the hedged return will be identical (no extra gains) 90 days Finish: 3. Simultaneously with euro investment, sell the €751 ,IOO forward at a rate of €0.73637/$ for delivery in 90 days, New York Today Start: 1. Convert $1 to euros at €0.7400/$ for€740,ooo. and receive $1 in 90 days. Alternative investment: €751 , 100 Frankfurt: 90 days Online Version Invest $1 in New York for 90 days at 2% and receive $1 in 90 days 2. Invest €740,000 at 1.5% for 90 days, yielding €751, 100 in 90 days. €740,000 Frankfurt: today 24
  25. Interest Rate Parity (IRP) Theory Covered Interest Arbitrage — If the covered interest differential between two money markets is nonzero, there is an arbitrage incentive to move money from one market to the other — Money is moved to take advantage of a covered interest differential — Transactions associated with covered interest arbitrage will affect prices in both the money and foreign exchange markets — Process of covered interest arbitrage will continue until interest parity is achieved, unless there is government interference Online Version 25
  26. Interest Rate Parity (IRP) Theory Relationship between the spot and forward rates and interest rates in a free market is given by interest parity line In reality, the interest parity line is a band due to: transaction costs arising from the spread on spot and forward contracts brokerage fees on security purchases and sales Online Version Interest differential in favor of home country (%) Parity line 5 4 3 2 -2 —3 —4 Arbitrage inflow to home country Arbitrage outflow from horne country 5 Forward premium (+) or discount (—) on foreign currency (%) 26
  27. Interest Rate Parity (IRP) Theory • Formal presentation of covered interest arbitrage relationship — eo : current spot rate (dollar value of one unit of foreign currency) — fl : nd-of-period forward rate — rh and rf: prevailing interest rates in HC and FC — One dollar invested in HC will yield 1+ rh at the end of the period — Same dollar invested in FC will be worth (1 + rf)f1/e0 dollars at maturity Online Version 27
  28. Interest Rate Parity (IRP) Theory Formal presentation of covered interest arbitrage relationship — Funds will flow from HCto FC if and only if; — Funds will flow from FC to HC if and only if; (l + rj)fl — Interest rate parity holds when there are no covered interest arbitrage opportunities (covered interest rate parity situation means there is no opportunity for arbitrage using forward contracts) Online Version eo 28
  29. Interest Rate Parity (IRP) Theory • Interest rate parity is approximated by: High interest rates on a currency are offset by forward discounts • Low interest rates are offset by forward premiums Online Version 29
  30. Interest Rate Parity (IRP) Theory Uncovered Interest Rate Parity (I-JIP): — Difference in interest rates between two countries will equal the relative change in currency foreign exchange rates over the same period — A country with the higher interest rate will experience depreciation in its domestic currency value relative to the foreign currency value with the lower interest rate — Assumptions of UIRP: • Capital mobility in the market • Non-arbitrage condition Online Version 30
  31. Interest Rate Parity (IRP) Theory Covered Interest Rate Parity vs. Uncovered Interest Rate Parity CIRP Use of future rates or forward rates when assessing exchange rates, which also makes potential hedging possible Difference between interest rates gets adjusted in the forward discount/premium - forward cover eliminates any risks associated with investments Online Version UIRP Considers expected rates, which implies forecasting future interest rates and involves the use of an estimation of the expected future rate Adjusts the difference between interest rates by equating the difference to the domestic currency's expected rate of depreciation - investors do not benefit from any forward cover 31
  32. Interest Rate Parity (IRP) Theory Empirical Evidence — Deviations from interest parity do occur between national capital markets due to capital controls, taxes on interest payments to foreigners and transaction costs — In the markets, forward rate is calculated from the interest differential between the two currencies using the no-arbitrage condition — Deviations of IRP tend to be small and short-lived A: Daily deviations from 90•day CIRP on US dollar/Deutsche mark 6 4 Online Version 32
  33. Relationship between the Forward Rate and the Future Spot Rate • In the absence of government intervention in the market, both the spot rate and the forward rate are influenced heavily by current expectations of future events The two rates move in tandem, with the link between them based on interest differentials • New information (a change in interest rate differentials) is reflected almost immediately in both spot and forward rates Online Version
  34. Relationship between the Forward Rate and the Future Spot Rate Equilibrium is achieved only when the forward differential equals the expected change in the exchange rate At the parity, there is _5 no longer any incentive to buy or sell the currency forward Online Version Expected change in home currency value of foreign currency (%) —3 -2 5 4 3 2 —2 Parity line 23,15 Forward premium (+) or discount (—) on foreign currency (%) 34
  35. Relationship between the Forward Rate and the Future Spot Rate Unbiased Forward Rate (UFR): forward rate should reflect the expected future spot rate on the date of settlement of the forward contract is the expected future exchange rate at time t (units of home currency per unit of foreign currency) and ft is the forward rate for settlement at time t Online Version 35
  36. Relationship between the Forward Rate and the Future Spot Rate Market efficiency requires that people process information and form reasonable expectations — risk averse investors will demand a risk premium on forward contracts — forward rate will not reflect exclusively the expectation of the future spot rate — currency risk is largely diversifiable and no risk premium need to be paid for holding a forward contract: forward rate and expected future spot rate will be approximately equal Online Version 36
  37. Currency Forecasting • Currency forecasting is difficult Currency forecasting can lead to consistent profits only if the forecaster meets at least one of the following: — Has exclusive use of a superior forecasting model — Has consistent access to information before other investors — Exploits small, temporary deviations from equilibrium — Can predict the nature of government intervention in the foreign exchange market Online Version 37
  38. Currency Forecasting Market-Based Forecasts — Current forward rates — Interest rate differentials Model-Based Forecasts — Fundamental Analysis — Technical Analysis Online Version CURRENCY A GUIDE TO FUNDAMENTAL AND TECHNICAL MODELS OF EXCHANGE RATE DETERMINATION FORECASTING Michael R. Rosenberg 38

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