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Foreign Exchange Markets. Dr Bryan Mills. Based on http://faculty.washington.edu/karpoff/FIN%20509/FIN509_session7.ppt. Outline of these slides. The foreign exchange (FX) market Basic questions and definitions Four theories Purchasing Power Parity Interest Rate Parity

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Foreign exchange markets

Foreign Exchange Markets

Dr Bryan Mills

Based on http://faculty.washington.edu/karpoff/FIN%20509/FIN509_session7.ppt


Outline of these slides
Outline of these slides

  • The foreign exchange (FX) market

  • Basic questions and definitions

  • Four theories

    • Purchasing Power Parity

    • Interest Rate Parity

    • Fisher condition for capital market equilibrium

    • Expectations theory of forward rates


1 the foreign exchange market
1. The Foreign Exchange Market

Sell

buy

Reuters 19/4/2010


The foreign exchange market
The Foreign Exchange Market...

Some forward currency rates as of May 24, 2004:

U.S. dollars per Euro (bid prices):

Spot rate 1.2017

One-month forward 1.20062

3 months forward 1.19898

6 months forward 1.19789

12 months forward 1.19854

24 months forward 1.19804


2 some basic questions
2. Some basic questions

  • Why aren’t FX rates all equal to one?

  • Why do FX rates change over time?

  • Why don’t all FX rates change in the same direction?

  • What drives forward rates – the rates at which you can trade currencies at some future date?


Definitions
Definitions

  • r$ : dollar rate of interest (r¥, rHK$,…)

  • i$: expected dollar inflation rate

  • f€/$ : forward rate of exchange

  • s€/$ : spot rate of exchange

    • “Indirect quote”:

      s€/$ = 0.83215  1 $ buys 0.83215 €

    • “Direct quote”:

      s$/€ = 1.2017  1 € buys $1.2017


3 four theories
3. Four theories

.

Fisher

Theory

Difference in

interest rates

1 + r€

1 + r$

Exp. difference in

inflation rates

1 + iSFr

1 + i$

Interest

Rate

parity

Relative PPP

Difference between

forward & spot rates

F€/$

s€/$

Expected change

in spot rate

E(s€/$)

S€/$

Exp. Theory

of forward

rates


Theory 1 purchasing power parity
Theory #1: Purchasing power parity

Law of One Price

Versions of

PURCHASING

POWER

PARITY

Absolute PPP

Relative PPP


The law of one price
The Law of One Price

  • A commodity will have the same price in terms of common currency in every country

    • In the absence of frictions (e.g. shipping costs, tariffs,..)

    • Example

      Price of wheat in France (per bushel): P€

      Price of wheat in U.S. (per bushel): P$

      S€/$ = spot exchange rate

P€ = s€/$ P$


The law of one price continued
The Law of One Price, continued

  • Example:

    Price of wheat in France per bushel (p€) = 3.45 €

    Price of wheat in U.S. per bushel (p$) = $4.15

    S€/$ = 0.83215 (s$/€ = 1.2017)

    Dollar equivalent price

    of wheat in France = s$/€ x p€

    = 1.2017 $/€ x 3.45 € = $4.15

     When law of one price does not hold, supply and demand forces help restore the equality


Absolute ppp
Absolute PPP

  • Extension of law of one price to a basket of goods

  • Absolute PPP examines price levels

    • Apply the law of one price to a basket of goods with price P€ and PUS (use upper-case P for the price of the basket):

      where P€ = i (wFR,i p€,i )

      PUS = i (wUS,i pUS,i )

S€/$ = P€ / PUS


Absolute ppp1
Absolute PPP

  • If the price of the basket in the U.S. rises relative to the price in Euros, the U.S. dollar depreciates:

    May 21 : s€/$ = P€ / PUS

    = 1235.75 € / $1482.07 = 0.8338 €/$

    May 24: s€/$ = 1235.75 € / $1485.01 = 0.83215 €/$


Relative ppp
Relative PPP

Absolute PPP:

For PPP to hold in one year:

P€ (1 + i€) = E(s€/$) P$ (1 + i$),

or: P€ (1 + i€) = s€/$ [E(s€/$)/s€/$ )] P$ (1 + i$)

Using absolute PPP to cancel terms and rearranging:

Relative PPP:

P€ = s€/$ P$

1 + i€ = E(s€/$)

1 + i$s€/$


Relative ppp1
Relative PPP

  • Main idea – The difference between (expected) inflation rates equals the (expected) rate of change in exchange rates:

1 + i€ = E(s€/$)

1 + i$s€/$


What is the evidence
What is the evidence?

  • The Law of One Price frequently does not hold.

  • Absolute PPP does not hold, at least in the short run.

    • See The Economist’s Big McCurrencies

  • The data largely are consistent with Relative PPP, at least over longer periods.


Deviations from ppp
Deviations from PPP

Simplistic model

Why does

PPP

not

hold?

Imperfect Markets

Statistical difficulties


Deviations from ppp1
Deviations from PPP

  • Transportation costs

  • Tariffs and taxes

  • Consumption patterns differ

  • Non-traded goods & services

  • Sticky prices

  • Markets don’t work well

  • Construction of price indexes

    - Different goods

    - Goods of different qualities

Simplistic model

Imperfect Markets

Statistical difficulties


Summary of theory 1
Summary of theory #1:

.

Exp. difference in

inflation rates

1 + i€

1 + i$

Relative PPP

Expected change

in spot rate

E(s€/$)

S€/$


Theory 2 interest rate parity
Theory #2: Interest rate parity

  • Main idea: There is no fundamental advantage to borrowing or lending in one currency over another

  • This establishes a relation between interest rates, spot exchange rates, and forward exchange rates

    • Forward market: Transaction occurs at some point in future

    • BUY: Agree to purchase the underlying currency at a predetermined exchange rate at a specific time in the future

    • SELL: Agree to deliver the underlying currency at a predetermined exchange rate at a specific time in the future


Example of a forward market transaction
Example of a forward market transaction

  • Suppose you will need 100,000€ in one year

  • Through a forward contract, you can commit to lock in the exchange rate

  • f$/€ : forward rate of exchange

    Currently, f$/€ = 1.19854  1 € buys $1.19854

     1 $ buys 0.83435 €

  • At this forward rate, you need to provide $119,854 in 12 months.


Interest rate parity
Interest Rate Parity

START (today)END (in one year)

r$=2.24%

$117,228

$117,228  1.0224 = $119,854

(Invest in $)

One year

s€/$=0.83215

f€/$=0.83435

(Invest in €)

$117,228  0.83215 = 97,551€

97,551€  1.0251 = 100,000€

r€=2.51%


Interest rate parity1
Interest rate parity

  • Main idea: Either strategy gets you the 100,000€ when you need it.

  • This implies that the difference in interest rates must reflect the difference between forward and spot exchange rates

    Interest

    Rate Parity:

1 + r€ = f€/$

1 + r$s€/$


Interest rate parity example
Interest rate parity example

  • Suppose the following were true:

    • Does interest rate parity hold?

    • Which way will funds flow?

    • How will this affect exchange rates?


Evidence on interest rate parity
Evidence on interest rate parity

  • Generally, it holds

  • Why would interest rate parity hold better than PPP?

    • Lower transactions costs in moving currencies than real goods

    • Financial markets are more efficient that real goods markets


Summary of theories 1 and 2
Summary of theories #1 and #2:

.

Difference in

interest rates

1 + r€

1 + r$

Exp. difference in

inflation rates

1 + i€

1 + i$

Interest

Rate

parity

Relative PPP

Difference between

forward & spot rates

f€r/$

s€/$

Expected change

in spot rate

E(s€/$)

s€/$


Theory 3 the fisher condition
Theory #3: The Fisher condition

  • Main idea: Market forces tend to allocate resources to their most productive uses

  • So all countries should have equal real rates of interest

  • Relation between real and nominal interest rates:

    (1 + rNominal) = (1 + rReal)(1 + i )

    (1 + rReal) = (1 + rNominal) / (1 + i )


Example of capital market equilibrium
Example of capital market equilibrium

  • Fisher condition in U.S. and France:

    (1 + r$(Real)) = (1 + r$) / (1 + i$)

    (1 + r€(Real)) = (1 + r€) / (1 + i€)

  • If real rates are equal, then the Fisher condition implies:

  • The difference in interest rates is equal to the expected difference in inflation rates

1 + r€ = 1 + i€

1 + r$ 1 + i$


Summary of theories 1 3
Summary of theories 1-3:

.

Fisher

Theory

Difference in

interest rates

1 + r€

1 + r$

Exp. difference in

inflation rates

1 + i€

1 + i$

Interest

Rate

parity

Relative PPP

Difference between

forward & spot rates

f€/$

s€/$

Expected change

in spot rate

E(s€/$)

s€/$


Theory 4 expectations theory of forward rates
Theory #4: Expectations theory of forward rates

  • Main idea:

    • The forward rate equals expected spot exchange rate

      Expectations theory

      of forward rates:

f€/$ = E(s€/$)

f€/$ = E(s€/$ )

s€/$s€/$


Expectations theory of forward rates
Expectations theory of forward rates

  • With risk, the forward rate may not equal the spot rate

  • If Group 1 predominates, then E(s€/$) < f€/$

  • If Group 2 predominates, then E(s€/$) > f€/$

  • Group 1:Receive €

  • in six months, want $

  • Wait six months and

  • convert € to $

  • or

  • Sell € forward

  • Group 2:Contracted to

  • pay out € in six months

  • Wait six months and

  • convert $ to €

  • or

  • Buy € forward


Takeaway summary of all four theories
Takeaway: Summary of all four theories

.

Fisher

Theory

Difference in

interest rates

1 + r€

1 + r$

Exp. difference in

inflation rates

1 + i€

1 + i$

Interest

Rate

parity

Relative PPP

Difference between

forward & spot rates

f€/$

s€/$

Expected change

in spot rate

E(s€/$)

s€/$

Exp. Theory

of forward

rates


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