International Corporate Finance Foreign Exchange Rate Determination Xin Chen Visiting Associate Professor Aarhus School of Business
1 International Corporate Finance Foreign Exchange Rate Determination Xin Chen Visiting Associate Professor Aarhus School of Business
Foreign Exchange Rate Determination Three major approaches to exchange rate determination: --International parity conditions. --Balance of payments. --Asset market approach. These are not competing theories but rather complementary theories
Foreign Exchange Rate Determination Three major approaches to exchange rate determination: --International parity conditions. --Balance of payments. --Asset market approach. These are not competing theories but rather complementary theories
Foreign Exchange Rate Determination the complexities of international political economy; societal and economic infrastructures;and, random political,economic,or social events affect the exchange rate markets
Foreign Exchange Rate Determination the complexities of international political economy; societal and economic infrastructures; and, random political, economic, or social events affect the exchange rate markets
Exhibit 7.1 The Determinants of Foreign Exchange Rates Parity Conditions 1.Relative inflation rates 2.Relative interest rates 3.Forward exchange rates 4.Interest rate parity Is there a well-developed Is there a sound and secure and liquid money and capital Spot banking system in place to market in that currency? Exchange support currency trading Rate activities? Asset Market Balance of Payments 1.Relative real interest rates 1.Current account balances 2.Prospects for economic growth 2.Portfolio investment 3.Supply and demand for assets 3.Foreign direct investment 4.Outlook for political stability 4.Exchange rate regimes 5.Speculation and liquidity 5.Official monetary reserves 6.Political risks and controls
Exhibit 7.1 The Determinants of Foreign Exchange Rates
International parity conditions approach The most widely accepted theory of all exchange rate determination theories. If all the international parity conditions are satisfied,then the expected change in the spot rate equals: The expected difference in inflation rates The difference in interest rates. The forward premium or discount
International parity conditions approach The most widely accepted theory of all exchange rate determination theories. If all the international parity conditions are satisfied, then the expected change in the spot rate equals: The expected difference in inflation rates. The difference in interest rates. The forward premium or discount
International parity conditions approach Do international parity conditions hold in the real world? PPP does not hold precisely in the real world: --Arbitrage only works for tradable goods. --Transportation costs. --Barriers to trade. 袋 PPP tends not to be accurate in predicting short-term changes in exchange rates,but gets empirical support at longer horizons
International parity conditions approach Do international parity conditions hold in the real world? PPP does not hold precisely in the real world: --Arbitrage only works for tradable goods. --Transportation costs. --Barriers to trade. PPP tends not to be accurate in predicting short-term changes in exchange rates, but gets empirical support at longer horizons
International parity conditions approach Do international parity conditions hold in the real world? Empirical tests indicate that the international Fisher effect performs poorly in predicting short-term changes in exchange rates. At longer horizons it appears that currencies with high interest rates tend to depreciate as predicted by the international Fisher effect
International parity conditions approach Do international parity conditions hold in the real world? Empirical tests indicate that the international Fisher effect performs poorly in predicting short-term changes in exchange rates. At longer horizons it appears that currencies with high interest rates tend to depreciate as predicted by the international Fisher effect
International parity conditions approach Do international parity conditions hold in the real world? Empirical evidence suggests that the forward rate is a biased predictor of the future exchange rate. We do not observe large and persistent 分 deviations from the interest rate parity Covered interest arbitrage is rare in practice
International parity conditions approach Do international parity conditions hold in the real world? Empirical evidence suggests that the forward rate is a biased predictor of the future exchange rate. We do not observe large and persistent deviations from the interest rate parity. Covered interest arbitrage is rare in practice
International parity conditions approach Covered vs uncovered interest arbitrage An investor observes the following data: --Spot rate between YEN and USD:S(YEN/USD)=118.611 --180 days forward rate between YEN and USD: F(YEN/USD)=117.800 --180 days US dollar interest rate (per annum): iUSD=4.8% --180 days Japanese yen interest rate(%per annum): iYEN 3.4%
International parity conditions approach Covered vs uncovered interest arbitrage An investor observes the following data: --Spot rate between YEN and USD: S(YEN/USD) = 118.611 --180 days forward rate between YEN and USD: F(YEN/USD) = 117.800 --180 days US dollar interest rate (% per annum): iUSD = 4.8% --180 days Japanese yen interest rate (% per annum): iYEN = 3.4%
International parity conditions approach Covered vs uncovered interest arbitrage The investor can always borrow 50,000 US dollars or the equivalent in any other currency. The investor believes that the yen is going to depreciate against the US dollar during the next 180 days.His expected exchange rate is S(YEN/USD)=125. 我 What is the covered interest arbitrage potential? 华 What is the uncovered interest arbitrage potential? What is the uncovered interest arbitrage profit if the spot rate turns out to be S(YEN/USD)=116 after 180 days? Assume that the US interest rate increases to 6%.Can the investor make a covered interest arbitrage profit?
International parity conditions approach Covered vs uncovered interest arbitrage The investor can always borrow 50,000 US dollars or the equivalent in any other currency. The investor believes that the yen is going to depreciate against the US dollar during the next 180 days. His expected exchange rate is S(YEN/USD) = 125. What is the covered interest arbitrage potential? What is the uncovered interest arbitrage potential? What is the uncovered interest arbitrage profit if the spot rate turns out to be S(YEN/USD) = 116 after 180 days? Assume that the US interest rate increases to 6%. Can the investor make a covered interest arbitrage profit?