International Banking

Prof. Alok Kumar

WE shall be discussing
Interest Rate Parity Covered Interest Arbitrage Interest Rate Parity Parity Purchasing Power IRP and Exchange Rate Determination Purchasing Power Parity PPP Deviations and the from Real Exchange Rate Reasons for Deviations IRP The Fisher Effects Evidence on Purchasing Power Parity The Fisher Effects Purchasing Power Parity Forecasting Exchange Rates The Fisher Effects Forecasting Exchange Rates Efficient Market Effects Approach The Fisher Forecasting Exchange Rates Fundamental Approach Forecasting Exchange Rates Technical Approach

Performance of the Forecasters

Interest Rate Parity

Interest Rate Parity Defined Covered Interest Arbitrage Interest Rate Parity & Exchange Rate Determination Reasons for Deviations from Interest Rate Parity

Interest Rate Parity Defined

IRP is an arbitrage condition. If IRP did not hold, then it would be possible for an astute trader to make unlimited amounts of money exploiting the arbitrage opportunity. Since we dont typically observe persistent arbitrage conditions, we can safely assume that IRP holds.

Interest Rate Parity Carefully Defined

Consider alternative one year investments for $100,000: 1. Invest in the U.S. at i$. Future value = $100,000 (1 + i$) 2. Trade your $ for at the spot rate, invest $100,000/S$/ in Britain at i while eliminating any exchange rate risk by selling the future value of the British investment forward.
Future value = $100,000(1 + i)

Since these investments have the same risk, they must have the same future value (otherwise an arbitrage would exist)
(1 + i)

F S

$/

$/

F S

$/

= (1 + i$)

$/

Alternative 2: Send your $ on a round trip to Britain $1,000

$1,000 S$/

IRP
Step 2: Invest those pounds at i Future Value =
$1,000 S$/ (1+ i)

Alternative 1: invest $1,000 at i$

$1,000(1 + i$) =

$1,000

Step 3: repatriate future value to the U.S.A.

(1+ i) F$/

S$/
IRP

Since both of these investments have the same risk, they must have the same future valueotherwise an arbitrage would exist

Interest Rate Parity Defined

The scale of the project is unimportant

$1,000 (1+ i) F$/ = $1,000(1 + i$) S$/ F$/ (1+ i) (1 + i$) = S$/

Interest Rate Parity Defined

Formally,

1+i F = 1+i S
$

$/

$/

IRP is sometimes approximated as i$ i F S S

Forward Premium
Its just the interest rate differential implied by forward premium or discount. For example, suppose the is appreciating from S($/) = 1.25 to F180($/) = 1.30 The forward premium is given by:

F180($/) S($/)

360 180 =

$1.30 $1.25 $1.25 2 = 0.08

f180,v$

S($/)

Interest Rate Parity Carefully Defined

Depending upon how you quote the exchange rate ($ per or per $) we have:

1 + i F = 1 + i$ S

/$

or

/$

1+i F = 1+i S
$

$/

$/

so be a bit careful about that

IRP and Covered Interest Arbitrage

If IRP failed to hold, an arbitrage would exist. Its easiest to see this in the form of an example. Consider the following set of foreign and domestic interest rates and spot and forward exchange rates.
Spot exchange rate U.S. discount rate British discount rate S($/) = $1.25/ i$ = 7.10% i = 11.56% 360-day forward rate F360($/) = $1.20/

IRP and Covered Interest Arbitrage A trader with $1,000 could invest in the U.S. at 7.1%, in
one year his investment will be worth $1,071 = $1,000 (1+ i$) = $1,000 (1,071) Alternatively, this trader could 1. Exchange $1,000 for 800 at the prevailing spot rate, 2. Invest 800 for one year at i = 11,56%; earn 892,48. 3. Translate 892,48 back into dollars at the forward rate F360($/) = $1,20/, the 892,48 will be exactly $1,071.

Alternative 2:

buy pounds 800 = $1,000 $1,000 1 $1.25

Arbitrage I
800 Step 2: Invest 800 at i = 11.56%

892.48 Step 3: repatriate to the U.S.A. at F360($/)

Alternative 1: invest $1,000 at 7.1% FV = $1,071

= $1.20/

In one year 800 will be 800 (1+ i) worth 892.48 =

$1,071 F(360) $1,071 = 892.48 1

Interest Rate Parity & Exchange Rate Determination

F360($/) = $1.20/ Why?

According to IRP only one 360-day forward rate, F360($/), can exist. It must be the case that

If F360($/) $1.20/, an astute trader could make money with one of the following strategies:

Arbitrage Strategy I
If F360($/) > $1.20/ i. Borrow $1,000 at t = 0 at i$ = 7.1%. ii. Exchange $1,000 for 800 at the prevailing spot rate, (note that 800 = $1,000$1.25/) invest 800 at 11.56% (i) for one year to achieve 892.48 iii. Translate 892.48 back into dollars, if F360($/) > $1.20/, then 892.48 will be more than enough to repay your debt of $1,071.

Step 2: buy pounds 800 = $1,000 $1,000

Arbitrage I
800 1 $1.25 892.48 Step 3: Invest 800 at i = 11.56% In one year 800 will be worth 892.48 = 800 (1+ i)

Step 1: borrow $1,000 More F(360) $1,071 < 892.48 Step 5: Repay than $1,071 1 your dollar loan with $1,071. If F (360) > $1.20/ , 892.48 will be more than enough to

Step 4: repatriate to the U.S.A.

repay your dollar obligation of $1,071. The excess is your

Arbitrage Strategy II
If F360($/) < $1.20/ i. Borrow 800 at t = 0 at i= 11.56% . ii. Exchange 800 for $1,000 at the prevailing spot rate, invest $1,000 at 7.1% for one year to achieve $1,071. iii. Translate $1,071 back into pounds, if F360($/) < $1.20/, then $1,071 will be more than enough to repay your debt of 892.48.

Step 2: buy dollars $1,000 = 800 $1,000

Arbitrage II
800

$1.25
1 Step 1: borrow 800

Step 5: Repay More Step 3: your pound than Invest loan with 892.48 $1,000 at i$ 892.48 . Step 4: repatriate to In one year the U.K. $1,000 will be $1,071 F(360) $1,071 > 892.48 worth 1

If F(360) < $1.20/ , $1,071 will be more than enough to repay your dollar obligation of 892.48. Keep the rest as

IRP and Hedging Currency Risk

You are a U.S. importer of British woolens and have just ordered next years inventory. Payment of 100M is due in one year.
Spot exchange rate U.S. discount rate British discount rate S($/) = $1.25/ i$ = 7.10% i = 11.56% 360-day forward rate F360($/) = $1.20/

IRP implies that there are two ways that you fix the cash outflow to a certain U.S. dollar amount: a) Put yourself in a position that delivers 100M in one yeara long forward contract on the pound. You will pay (100M)(1.2/) = $120M in one year. b) Form a forward market hedge as shown below.

IRP and a Forward Market Hedge

To form a forward market hedge: Borrow $112.05 million in the U.S. (in one year you will owe $120 million). Translate $112.05 million into pounds at the spot rate S($/) = $1.25/ to receive 89.64 million. Invest 89.64 million in the UK at i = 11.56% for one year. In one year your investment will be worth 100 millionexactly enough to pay your supplier.

Forward Market Hedge

Where do the numbers come from? We owe our supplier 100 million in one yearso we know that we need to have an investment with a future value of 100 million. Since i = 11.56% we need to invest 89.64 million at the start of the year.
100
89.64 = 1.1156 How many dollars will it take to acquire 89.64 million at the start of the year if S($/) = $1.25/?

$1.00
$112.05 = 89.64 1.25

Reasons for Deviations from IRP

Transactions Costs
The interest rate available to an arbitrageur for borrowing, ib,may exceed the rate he can lend at, il. There may be bid-ask spreads to overcome, Fb/Sa < F/S Thus

(Fb/Sa)(1 + il) (1 + i b) 0 Capital Controls

Governments sometimes restrict import and export of money through taxes or outright bans.

Transactions Costs Example

Will an arbitrageur facing the following prices be able to make money? 1 + i$ F$/ Borrowing Lending $ 5% 6% 4.50% 5.50%

1+i

$/

Bid Ask Spot $1.00=1.0 $1,01=1,00 0 Forward $0.99=1.0 $1.00=1.00 0

Transactions Costs Example

Try borrowing $1.000 at 5%: Trade for at the ask spot rate $1.01 = 1.00 Invest 990.10 at 5.5% Hedge this with a forward contract on 1,044.55 at $0.99 = 1.00 Receive $1.034.11 Owe $1,050 on your dollar-based borrowing Suffer loss of $15.89

Now try this backwards

Purchasing Power Parity

Purchasing Power Parity and Exchange Rate Determination PPP Deviations and the Real Exchange Rate Evidence on PPP

 The exchange rate between two currencies should equal the ratio of the countries price levels:

Purchasing Power Parity and Exchange Rate Determination

P$ S($/) = P

For example, if an ounce of gold costs $300 in the U.S. and 150 in the U.K., then the price of one pound in terms of dollars should be: P$ $300 S($/) = = = $2/ P 150

Purchasing Power Parity and Exchange Rate Determination

Suppose the spot exchange rate is $1.25 = 1.00 If the inflation rate in the U.S. is expected to be 3% in the next year and 5% in the euro zone, Then the expected exchange rate in one year should be $1.25(1.03) = 1.00(1.05)

$1.25 (1.03) F($/) = 1.00(1.05)

$1.23 1.00

 The euro will trade at a 1.90% discount in the forward market:

Purchasing Power Parity and Exchange Rate Determination

F($/) = S($/)
$1.25(1.03) 1.00(1.05) $1.25 1.00

1.03 1 + $ = = 1.05 1 +

Relative PPP states that the rate of change in the exchange rate is equal to differences in the rates of inflationroughly 2%

Purchasing Power Parity and Interest Rate Parity

Notice that our two big equations today equal each other:

PPP
F($/) 1 + $ = S($/) 1 +
=

IRP
1 + i$ F($/) = 1 + i S($/)

Expected Rate of Change in Exchange Rate as Inflation Differential

We could also reformulate our equations as inflation or interest rate differentials:

F($/) 1 + $ = S($/) 1 +

F($/) S($/) 1 + $ 1 + $ 1 + = 1= S($/) 1 + 1 + 1 + E(e) = F($/) S($/) $ $ = S($/) 1 +

Expected Rate of Change in Exchange Rate as Interest Rate Differential

E(e) =

F($/) S($/) i$ i = S($/) 1 + i

i$ i

Quick and Dirty Short Cut

Given the difficulty in measuring expected inflation, managers often use

$ i$ i

Evidence on PPP
PPP probably doesnt hold precisely in the real world for a variety of reasons.
Haircuts cost 10 times as much in the developed world as in the developing world. Film, on the other hand, is a highly standardized commodity that is actively traded across borders. Shipping costs, as well as tariffs and quotas can lead to deviations from PPP.

PPP-determined exchange rates still provide a valuable benchmark.

Approximate Equilibrium Exchange Rate Relationships

E(e )
PPP IRP

IFE

FEP

(i$ i)

FS

S
FE
E($ )

FRPPP

The Exact Fisher Effects

An increase (decrease) in the expected rate of inflation will cause a proportionate increase (decrease) in the interest rate in the country. For the U.S., the Fisher effect is written as: 1 + i$ = (1 + $ ) E(1 + $) Where $ is the equilibrium expected real U.S. interest rate E($) is the expected rate of U.S. inflation i$ is the equilibrium expected nominal U.S. interest rate

International Fisher Effect

If the Fisher effect holds in the U.S. 1 + i$ = (1 + $ ) E(1 + $) and the Fisher effect holds in Japan, 1 + i = (1 + ) E(1 + ) and if the real rates are the same in each country $ = then we get the International Fisher Effect:

E(1 + ) 1 + i = 1 + i$ E(1 + $)

International Fisher Effect

If the International Fisher Effect holds,

E(1 + ) 1 + i = 1 + i$ E(1 + $)

and if IRP also holds 1 + i F = 1 + i$ S

/$ /$

then forward rate PPP holds:

F S

/$

/$

E(1 + ) = E(1 + $)

Exact Equilibrium Exchange Rate Relationships E ( S )

/$
IFE

S /$
PPP

FEP

1 + i 1 + i$

IRP

F / $ S /$
FRPPP

FE E(1 + ) E(1 + $)

Forecasting Exchange Rates

Efficient Markets Approach Fundamental Approach Technical Approach Performance of the Forecasters

Efficient Markets Approach

Financial Markets are efficient if prices reflect all available and relevant information. If this is so, exchange rates will only change when new information arrives, thus: St = E[St+1] and Ft = E[St+1| It] Predicting exchange rates using the efficient markets approach is affordable and is hard to beat.

Fundamental Approach
Involves econometrics to develop models that use a variety of explanatory variables. This involves three steps:
step 1: Estimate the structural model. step 2: Estimate future parameter values. step 3: Use the model to develop forecasts.

The downside is that fundamental models do not work any better than the forward rate model or the random walk model.

Technical Approach
Technical analysis looks for patterns in the past behavior of exchange rates. Clearly it is based upon the premise that history repeats itself. Thus it is at odds with the EMH

Performance of the Forecasters

Forecasting is difficult, especially with regard to the future. As a whole, forecasters cannot do a better job of forecasting future exchange rates than the forward rate. The founder of Forbes Magazine once said: You can make more money selling financial advice than following it.

Thank You