Exchange Rates , Interest
Rates and Interest Parity
If expected exchange rate on a similar instrument is
greater in one nation with another.
No restrictions on capital flows.
Savers move funds from one nation to another.
Expected Int Rates and Term Structure of
Interest Rates
■ There is no such thing as the interest rate
of a country.
■ The interest rates within a country vary for
different investment opportunities and for
different maturity dates.
■ The structure of interest rates existing on
investment opportunities over time is
known as the term structure of int rates.
Theories on Term Structure
■ Expactations; This theory suggests long
term interest rate tends to be equal to an
average of short term rates expected over
the long term holding period.
■ Liquidity premium; Underlying this theory
is the idea the premium on long term
bonds is interest rising with the holding
period of the bond.
Theories on Term Structure
■ Preffered Habitat ; This approach contends that
the bond markets are segmented by maturities.
■ In other words there is a separate market for
short-long term bonds and the interest rates are
determined by supply and demand in each
market.
■ In international finance we use term structures
for different currencies to infer expected
exchange rates.
Flow of Funds-Interest Rates
■ Flow of funds potentially affect interest
rates in both nations
■ Exchange rates btw currencies.
■ In a competitive market the supply of and
demand for funds available for lending
determine interest rates.
Interest Parity
■ Relationship results from profit seeking
arbitrage activity.
■ If expected returns of two similar
instruments are different savers would
move funds from one instrument to
another.
Example interest parity
■ Consider a resident of the USA willing to
place dollar savings either in U.S treasury
bill or U.K treasury bill.
■ Both instruments have the same risk
characteristics.
EXAMPLE
■ U.S interest rate : R
■ U.K interest rate : R*
■ Spot exchange rate of dollars-per uk
pounds denoted by S
Example
■ İndividual places dollar savings in U.S
treasury bill one year later : 1+R dollars
accumulated.
■ İnd places dollar savings in UK treasury
bills .First he must exchange each dollar
for british pounds at the spot exchange
rate of s dollars per pound to obtain 1/s
pounds.
■ 1 year later: (1/S) (1+R*) British pounds.
Example
■ Thirdly US resident will convert her pounds
to dollars.
■ If S+1 is the spot exchange rate at the
future maturity .
■ Then the realized return on the UK
treasury bill will be ( 1/S) (1+R*) S+1
dollars
Expected Return
■ At the time the individual is deciding on
which instrument to purchase.The US
saver does not know what the spot rate
will be when the instrument matures.
■ The ind bases her decision on her
expectations of spot rate at the time of
maturity.
Expected Return
■ (1/S) (1+R*) Se+1
■ In other words the saver anticipates that
the accumulated (1/S) (1+ R*) British
pounds will exchange at the expected
future spot exchange rate , Se+1 for an
accumulated savings in dollars of ( 1/S)
(1+R*)Se+1
Forward Premium
The difference between the spot and forward
rates.
Ex: spot rate is 1.6035 ($/pound) and the 3month forward rate is 1.6050
The forward premium on the pound is:
( (1.6050-1.6035)/ 1.6035). (12/3).100 =
0.37%.
Covered Interest Parity
■ Covered interest parity is a condition that
relates interest differentials to the forward
premium .
■ It begins with the interest parity condition
■ (1+R) = (1+ R*) ( F/S)
■ The condition can be rewritten as R-R*=
( F-S) /S
Covered Interest Parity
■ CIP is useful to understand short-term
market movements.
■ As an equlibrium condition it aids
understanding potential adjustments in
various financial markets
■ These adjustments occur if there is a flow
of savings from one nation to another.
Example
■ Suppose 90 days US interest rate is 5.5%
■ Uk interest rate for 90 days is 5.0%
■ The current spot rate is 1.4546($/pound)
■ Three months forward rate is 1.4900
Example
■ To use the uncovered interest rate parity
condition convert interest rates to quarterly
values.
■ (0.055)/ (12/3) = 0.01375 and (0.05) /
(12/3) = 0.0125
■ Now substitute the values of CIP condition.
Example
■ 0.01375-0.0125=
(1.4900-1.4546)/1.4546
■ 0.00125< 0.0243.
■ Though the interest rate on US instrument
is higher than the UK instrument.
■ The difference is outweighed by the
depreciation ( forward discount) of the
dollar over the time interval.
Conclusion
■ Funds would flow from USA to UK.
■ This flow of funds could impact interest
rates in both countries ; forward exchange
rate and the spot rate.
Uncovered Interest Parity
■ In covered interest rate parity we
considered financial arbitrage made by an
individual who hedged all of the foreign
exchange risk by making use of a forward
exchange contract.
■ Now individual does not use forward
exchange contract.
Uncovered Interest Rate Parity
■ Why someone might not choose to use a forward
exchange contract to hedge risk?
■ Transaction might not be large enough to
warrant a forward contract to hedge risk.
■ R-R*= Se+1 – S / S
■ This is a condition relating the interest rate
differential of similar financial instruments of two
nations to the expected change in the spot
exchange rate btw the two nations.
Uncovered Interest Rate Parity
■ In equilibrium the interest differential btw
two similar financial instruments should be
approximately equal to the expected
depreciation or appreciation of the foreign
currency.
UIP Conclusion
■ If foreign exchange risk is not hedged
when purchasing a foreign financial
instrument , the transaction is said to be
uncovered.
■ If the saving decision is uncovered , the
individual is basing their decision on their
expectation of the future spot exchange
rate.
UIP Conclusion
■ The expected future spot exchange rate is
expressed as Se+1.
■ Using this expression UİP can be written as
, R-R* = ( Se+1 –S ) /S ( expected change
in the spot rate over the relevant time
period).
UIP Conclusion
■ According to UIP , if the domestic interest rate is
greater than the foreign interest rate the
domestic currency is expected to depreciate over
the relevant time period.
■ Likewise if the domestic interest rate is less than
the foreign interest rate , the domestic currency
is expected to appreciate over the relevant time
period.
■ UIP can be useful in understanding why funds
may flow from one economy to another.
Interest Rates and Inflation
■ To link exchange rates , interest rates and
inflation we must understand the role of
inflation in interest rate determination.
■ Nominal vs Real interest rates
■ Nominal: actually observed in the market
■ Real: Concept that measures the return
after adjusting for inflation.
Fisher Effect
■ The expected effect of inflation on the nominal
interest rate is called the Fisher effect. i= r+ıı
■ Ex: If you loan someone money and charge that
person 5% interest on the loan , the real return
on your loan is negative if the inflation rate
exceeds 5%.
■ Thus an increase in ıı will tend to increase i.
■ Nominal interest rates tend to be higher in
countries with higher rates of inflation.
Exchange Rates , Int Rates and Inflation
■ If we combine the Fisher equation and the
interest parity equation we can determine
how interest rates , inflation and exchange
rates are all linked.
■ First consider Fisher equation for USA and
UK.
■ If the real interest rate is the same
internationally then nominal interest rates
differ solely by expected inflation.
Exchange Rates Int Rates and Inflation
■ The interest parity condition indicates that
the interest differential is also equal to the
forward premium.
■ In the real world the interest rates ,
inflation , expectations and exchange rates
are jointly affected by new events and
information.
Expected Exchange Rates and the Term
Structure of Interest Rates
■ The structure of interest rates existing on
investment opportunities over time is
known as term structure of interest rates.
■ If the interest rates rise within the term to
maturity then we observe a rising term
structure.
■ If the int rates were the same regardless
of term term structure would be flat.
Term Structure Theories
■ Expectations ; Long term interest rates tends to
be equal to an average short term rates expected
over the long-term holding period.
■ Liquidity Premium ; The premium on long term
bonds would tend to result in interest rising with
the holding period of the bond.
■ Preffered Habitat ; There is a separate market for
long term and short term bonds and the interest
rates are determined by supply and demand in
each market.
Term Structure
■ In International Finance we use term
structures for different currencies to infer
expected exchange rates.
■ By examining the different points in term
structure we can determine how the
exchange rate expectations are changing
through time.
Term Structure
■ Each point in the term structure the difference
btw the national interest rates should reflect the
expected change in the exchange rate for the two
currencies.
■ If the two term structure lines are parallel then
the exchange rate changes are expected to be
constant.
■ On the other hand if the two term structure lines
are diverging or moving apart then the high
interest rate currency is expected to depreciate at
an increasing rate over time.