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Copyright 2009 Pearson Prentice Hall. All rights reserved.
Chapter 2
Foreign
Exchange
Parity
Relations
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Introduction
In this chapter we look at:
Foreign exchange fundamentals; in particular
the balance of payments and exchange rate
regimes. Describe the factors that cause a nations
currency to appreciate or depreciate.
International parity relations.
Define and discuss the International Fisher
relation.
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Introduction
Discuss the implications of the parity
relationships combined.
Exchange rate determination theories and their
potential implications. Discuss the asset markets approach to pricing
exchange rate expectations.
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Supply and Demand for Foreign
Exchange
In general, there are many types oftransactions that affect the demand and
supply of one national currency.
From an accounting viewpoint, eachcountry keeps track of the payments on all
international transactions in its balance of
payments.
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Exhibit 2.1: Foreign Exchange Market
Equilibrium
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Balance of Payments
The balance of payments tracks all financialflows crossing a countrys borders during a
given period (a quarter or a year).
A balance of payments is not an incomestatement nor a balance sheet.
The convention is to treat all financial
inflows as a credit to the balance ofpayments.
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Balance of Payments
An export, for example, creates a financialinflow for the home country, whereas an
import creates an outflow.
There are two main categories:
Current account
Financial account
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Current Account
Covers all current transactions that take place inthe normal business of residents of a country.
Dominated by the trade balance, the balance of allexports and imports.
Made up of:
Exports and imports (trade balance)
Services
Income
Current transfers
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Current Account
It also covers: Services (such as services in transportation,
communication, insurance and finance).
Income (interest, dividends and various investment
income from cross-border investments). Current transfers (flows without quid pro quo
compensation).
A current account deficit is not necessarily a bad
economic signal as long as nonresidents arewilling to offset it by investment flows.
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Financial Account
Covers investments by residents abroad andinvestments by nonresidents in the home country.
It includes:
Direct investment made by companies.
Portfolio investments in equity, bonds and other
securities of any maturity.
Other investments and liabilities (such as deposits or
borrowing with foreign banks and vice versa).
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Financial Account
The sum of the current and financialaccounts should be zero.
Question: What if the overall balance is
negative?
Answer: The central bank can use up part of
its reserves to restore a zero balance.
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Capital and Financial Account
The Capital Accountincludes unrequited(unilateral) transfers corresponding to capital
flows without compensation such as foreign aid,
debt forgiveness and expropriation losses. This is
typically a very small account with a misleading
title. It is often aggregated with the financial
account (capital and financial account).
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Capital and Financial Account
Similarly,Net Errors and Omissions(orstatistical discrepancy) are usually
aggregated with the capital and financial
account. To be sustained, a current account deficit
must be financed by a financial account
surplus.
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Exhibit 2.2: U.S. Balance of Payments
for 2004
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Balance of Payments Equilibrium
The sum of the current account and of the capitaland financial account is called the overall balance
and should be zero in the absence of government
intervention.
The official reserve account tracks all reserve
transactions by the monetary authorities.
By accounting definition, the overall balance must
mirror the official reserve account.
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Differences in Economic Performance
Financial flows are attracted by highexpected return, but also by low risk.
Desired Attributes:
A stable political system
A rigorous but fair legal system
A fair tax system
Free movements of capital
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Factors That Cause a Nations Currency
to Appreciate or Depreciate
In a flexible exchange rate system, the valueof a currency is driven by changes in
fundamental economic factors.
Amongst the factors are: Differences in national inflation rates.
Changes in real interest rates.
Differences in economic performance. Changes in investment climate.
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Exchange Rate Regimes
Historically, there have been three differentregimes:
Flexible (or Floating) Exchange Rates
Fixed Exchange Rates
Pegged Exchange Rates
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Flexible (Floating) Exchange Rate
Regime
One in which the exchange rate between twocurrencies fluctuates freely in the foreignexchange market.
Advantage
The exchange rate is a market-determined price thatreflects economic fundamentals at each point in time.
Governments are free to adopt independent domesticmonetary and fiscal policies.
Disadvantage Quite volatile exchange rates.
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Fixed Exchange Rate Regime
One in which the exchange rate between twocurrencies remains fixed at a preset level, knownas official parity.
Advantages:
Eliminates exchange rate risk, at least in the short run.
Brings discipline to government policies.
Disadvantages:
Deprives the country of any monetary independence.
Also constrains countrys fiscal policy.
Its long-term credibility
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Currency Board
Today some countries try to maintain afixed exchange rate regime against the
dollar or euro.
This is done through a currency board
The supply of home currency is fully
backed by an equivalent amount of that
major currency.
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Pegged Exchange Rate Regime
Characterized as a compromise between a flexibleand a fixed exchange rate. The exchange rate is allowed to fluctuate within a
(small) band around a target exchange rate (peg) andthe target exchange rate is periodically revised to reflect
changes in economic fundamentals. Advantages
Reduces exchange rate volatility in the short run.
Also encourages monetary discipline for the home
country. Disadvantage
Can induce destabilizing speculation.
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International Parity Relations
The parity relations of international financeare as follows:
Interest rate parity relation
Purchasing power parity relation. International Fisher relation.
Uncovered interest rate parity relation.
Foreign exchange expectation relation.
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International Parity Relations: Definitions
The term spotrate (S) refers to the exchange ratefor immediate delivery.
The forward rate (F) is set on one date for
delivery at a future specified date. For example,the $: forward exchange rate for delivery in six
months might be F = 106.815 yen per dollar.
rFCand rDCare the foreign and domestic interest
rates (annualized). IFC and IDCare the foreign and domestic inflation
rates (annualized).
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Interest Rate Parity Relation
Interest rate parity is the relation that theforward discount (premium) equals the
interest rate differential between two
currencies. Indicates that what we gain on the interest
rate differential, we lose on the discount on
the forward contract.
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Interest Rate Parity Relation
Exact relationF/S = (1 + rFC)/(1 + rDC)
Linear approximation
= F/S -1 rFC- rDC
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Parity Relations
Thepurchasing power parityrelation,linking spot exchange rates and inflation.
TheInternational Fisher relation, linking
interest rates and expected inflation. The uncovered interest rate parityrelation,
linking spot exchange rates, expectedexchange rates and interest rates.
Theforeign exchange expectation relation,linking forward exchange rates andexpected spot exchange rates.
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Purchasing Power Parity (PPP) Relation
PPP states that the spot exchange rateadjusts perfectly to inflation differentials
between two countries.
There are two versions of PPP: Absolute PPP
This claims that the exchange rate should be equal
to the ratio of the average price levels in the two
economies.
Relative PPP
Focuses on the general across the board inflation
rates.
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Purchasing Power Parity (PPP) Relation
Relative PPP This claims that the percentage movement of
the exchange rate should be equal to the
inflation differential between the twoeconomies
The PPP relation is presented as:
Exact
S1/S0= (1 + IFC)/(1 + IDC)
Linear approximation
s = S1/S01 IFC- IDC
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Purchasing Power Parity (PPP) Relation
PPP says that what you gain with lowerdomestic inflation, you can expect to lose
on foreign currency depreciation when you
invest in foreign currency assets.
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International Fisher Relation
Claims that the interest rate differential between
two countries should be equal to the expected
inflation rate differential over the term of the
interest rate.
The International Fisher Relationcan be
represented as:
Exact
(1 + rFC)/(1 + rDC) = (1 + E(IFC))/(1 + E(IDC))
Linear approximation
rFCrDCE(IFC) - E(IDC)
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Example
Question:How are the nominal and realinterest rates calculated?
Answer:Nominal interest rate is observed
in the marketplace. The real interest rate iscalculated from the observed interest rate
and forecasted inflation.
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Uncovered Interest Rate Parity Relation
This is a theory combining purchasing powerparity and the international Fisher relation.
It refers to the exchange rate exposure not coveredby a forward contract.
It claims the expected change in the indirectexchange rate approximately equals the foreignminus the domestic interest rate.
It can be represented as:
Exact
E(S1)/S0= (1 + rFC)/(1 + rDC)
Linear Approximation
E(s) = E(S1)/S01 rFC- rDC
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Foreign Exchange Expectation Relation
This relation states that the forwardexchange rate, quoted at time 0 for delivery
at time 1, is equal to the expected value of
the spot exchange rate at time 1. This can be written as:
F = E(S1)
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Combining Relations - Summary
Interest rate differential:forward discount (premium)equals the interest rate differential.
Inflation differential:exchange rate movement shouldexactly offset any inflation differential.
Expected inflation rate differential:expected inflationrate differential should be matched by the interest ratedifferential, assuming (Fisher) real interest rates areequal.
The interest rate differential:expected to be offset by thecurrency depreciation.
The expected exchange rate movement:forward discount(or premium) is equal to the expected exchange ratemovement.
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Summary of Parity Relations
Exhibit 2 3: International Parity
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Exhibit 2.3: International Parity
Relations Linear Approximation
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Exchange Rate Determination
The following approaches are proposed: Fundamental value based on relative PPP
Balance of Payments Approach
Asset Market Approach
F d t l V l B d R l ti
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Fundamental Value Based on Relative
PPP
Such estimation is not an easy task and exchangerates can become grossly misaligned and remain
so for several years without a correction.
This correctionwill usually take place, but it may
take several years and its timing is unclear.
Additional models are needed to provide a better
understanding of exchange rate movements.
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Balance of Payments Approach
An analysis of balance of payments provided thefirst approach to the economic modeling of theexchange rate.
The four component groups include the current
account, financial account, capital account andofficial reserves account.
An imbalance in some account could lead to adepreciation or appreciation of the home currency.
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Sources of Data for BOP
Customs data
Central bank stats
Bank reports of transactions
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BOP Components
Current Account
Capital account
Financial account
Official reserve account
Exhibit 2 5: Balance of Payments
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Exhibit 2.5: Balance of Payments
and the Dollar Exchange Rate
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Asset Market Approach
This approach claims that the exchange rate is therelative price of two currencies, determined by
investorsexpectations about the future, not by
current trade flows.
News(unexpected information) about future
economic prospects should affect the current
exchange rate.
Several types of news influence exchange rates.
Asset Market Approach:
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Asset Market Approach:
A Simple Example
Lets consider a one-time sudden and unexpected increasein the domestic money supply that will lead to higher home
inflation.
The long-runexchange rate effect is a depreciation of the
home currency so that purchasing power parity ismaintained as the percentage increase in the price level
matches the percentage increase in the money supply.
Given sticky-goods prices, theshort-runexchange rate
effect is an immediate drop in the real interest rate andmore depreciation of the currency than the depreciation
implied by purchasing power parity.
E hibi 2 6
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Exhibit 2.6:
ExchangeRate
Dynamics
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