Docstoc

Exec_TopicsExchangeRates

Document Sample
Exec_TopicsExchangeRates Powered By Docstoc
					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
                                              HK $1000
                              St
         Uncovered Interest Parity
               (1  i F )  St 1
• If                                  > 1+i, deposit funds
                       St

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.
• Approximately             St 1  St
                 ii   F

                             St
         0
             2
                 4
                     6
                                    8
                                         10
                                              12
                                                   14
Apr-92

Apr-93

Apr-94

Apr-95

Apr-96

Apr-97

Apr-98

Apr-99

Apr-00

Apr-01

Apr-02

Apr-03

Apr-04
                                 India
                                                        International Interest Rates




                     Hong Kong
Ap




          0
              1
                  2
                      3
                          4
                              5
                                  6
                                      7
  r- 9
      2
Ap
  r- 9
      3
Ap
  r- 9
      4
Ap
  r- 9
      5
Ap
  r- 9
      6
Ap
  r- 9
      7
Ap
  r- 9
      8
Ap
  r- 9
      9
                                          Rupees per HK$




Ap
  r- 0
      0
Ap
  r- 0
      1
Ap
  r- 0
      2
Ap
  r- 0
      3
Ap
                                                           Exchange Rate Appreciation




  r- 0
      4
Thai Interest Rates and the
      Dollar/Baht Rate
                                                     .32

                                                     .28

                                                     .24

  16                                                 .20

                                                     .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

                                                         1  it
                                             Ft  St 
•   This implies a forward price.                                 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
                                         %




                     0
                         2
                             4
                                 6
                                     8
                                         10
                                              12
                                                   14
                                                        16
                                                             18
                                                                  20
            Jun-86

            Jun-87

            Jun-88

            Jun-89

            Jun-90

            Jun-91

            Jun-92

            Jun-93

            Jun-94

            Jun-95




Fed Funds
            Jun-96
                                                                       Interbank Rates




            Jun-97



HIBOR
            Jun-98

            Jun-99

            Jun-00

            Jun-01

            Jun-02

            Jun-03
                                                                                         HIBOR vs. Fed Funds Rate




            Jun-04
      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     Fixed     Band     Crawling   Managed   Free Float
                     Board     Exchange               Peg       Float
                                 Rate



     Source http://www.imf.org/external/np/mfd/er/2005/eng/1205.htm
     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

                                              CPI t
     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    2006
  2002 was .9 meaning
  goods that cost $1 in
  the US cost €.90 in     CPI-      104.5   117.1
  Germany.                USA
• But prices (and         CPI-      103.3   110.2
  exchange rates) have    Germany
  changed since then.
                          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.
               gt   t
                   S      HOME
                               t    US $
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%              2.00%        4.00%           6.00%   8.00%

                       Inflation Differential   Exchange Rate Depreciation
         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.

				
DOCUMENT INFO
Shared By:
Categories:
Tags:
Stats:
views:5
posted:5/17/2012
language:
pages:25
fanzhongqing fanzhongqing http://
About