InternationalEconomics

EC3024

University of Aberdeen

ExchangeRates

Catia Montagna
University of Aberdeen
Scottish Institute for Research in Economics (SIRE)
Centre for Globalisation and Economic Policy (Nottingham)
Tuborg Research Centre for Globalisation and Firms (Aarhus)

ExchangeRates
Threeimportantcharacteristicsoftheworld
economy
1. Theworldhasmanymonies(notone)
2. Countriesarefinanciallyintegrated(not
isolated)toaconsiderabledegree
2. Economicpolicychoicesmadeinone
countryaffectothercountrieseconomies
(policyinterdependence)
3

ExchangeRates
Countrieshavedifferentcurrencies,thereforea
completeunderstandingofhowacountrys
economyworksrequiresthatwestudythe
exchangerate (thepriceofforeigncurrencies)
Becausegoodsandinvestmentsmoveacross
borders,fluctuationsinexchangerateshave
significanteffectsontherelativepricesofhome
andforeign:
o Goods(suchasautosandclothing)
o Services(suchasinsuranceandtourism)
o Assets(suchasequitiesandbonds)
4

ExchangeRates
Anexchangerate(E)isthepriceofsomeforeign
currencyexpressedintermsofahome(ordomestic)
currency
Becauseanexchangerateistherelativepriceoftwo
currencies,itmaybequotedineitheroftwoways:
o Thenumberofhomecurrencyunitsthatcanbe
exchangedforoneunitofforeigncurrency
o Thenumberofforeigncurrencyunitsthatcanbe
exchangedforoneunitofhomecurrency
Onequotationisthereciprocal oftheother
5

ExchangeRates
Toavoidconfusion,wemustspecifywhichcountry
isthehome countryandwhichistheforeign one
Whenwerefertoaparticularcountrysexchange
rate,wewillquoteitintermsof unitsofhome
currencyperunitsofforeigncurrency
Forexample,Denmarksexchangeratewiththe
EurozoneisquotedasDanishkronepereuro:
Kr/ =numberofunitsofKrrequiredtobuy1
(Wecanthinkofthisasthepriceof1 intermsofKr)
6

ExchangeRateQuotationsThistableshowsmajorexchangeratesastheymightappearinthe
financialmedia.Columns(1)to(3)showratesonDecember31,2012.Forcomparison,
columns(4)to(6)showratesonDecember31,2011.Forexample,column(1)showsthatat
theendof2012,oneU.S.dollarwasworth0.996Canadiandollars,5.659Danishkrone,0.759
euros,andsoon.Theeurodollarratesappearinboldtype.

E$/ =1.318=U.S.exchangerate(Americanterms)
E/$ =0.759=Eurozoneexchangerate(Europeanterms)

E$/

1
1
1
.318
=
=
0.759
E /$

ExchangeRateRegimes
Therearetwomajortypesofexchangerate
regimesfixed andfloating:
Fixed (orpegged)exchangerates fluctuateina
narrowrange(ornotatall)againstsomebase
currencyoverasustainedperiod
Acountrysexchangeratecanremainrigidlyfixedfor
longperiodsonlyifthegovernmentintervenesinthe
foreignexchangemarketinoneorbothcountries

ExchangeRateRegimes
Therearetwomajortypesofexchangerate
regimesfixedandfloating:
Floating(orflexible)exchangeratesfluctuateina
widerrange,andthegovernmentmakesnoattempt
tofixitagainstanybasecurrency
Appreciationsanddepreciationsmayoccurfrom
yeartoyear,eachmonth,bytheday,orevery
minute

ExchangeRateRegimes
ExchangeRateRegimesThe
piechartshowsa
classificationofexchange
rateregimesaroundthe
worldusingthemostrecent
datafortheyear2010.

ExchangeRateRegimes
Despitethe abundanceofcurrencies,wealsoseenewly
emergingformsofmonetaryorganization.
Somegroupsofcountrieshavesoughttosimplifytheir
transactionsthroughtheadoptionofacommoncurrency
withsharedpolicyresponsibility.Themostnotableexample
istheEurozone.
Stillothercountrieshavechosentousecurrenciesover
whichtheyhavenopolicycontrol,aswiththerecentcasesof
dollarization inElSalvadorandEcuador.

ExchangeRateBehaviour
ExchangeRateBehavior:SelectedDevelopedCountries,19962012

ThisfigureshowstheexchangeratesofthreecurrenciesagainsttheU.S.dollar
TheU.S.dollarisinafloatingrelationshipwiththeyen,thepound,andtheCanadian
dollar
TheU.S.dollarissubjecttoagreatdealofvolatilitybecauseitisinafloatingregime,or
freefloat

ExchangeRateBehaviour
ExchangeRateBehavior:SelectedDevelopedCountries,19962012

Thisfigureshowsexchangeratesofthreecurrenciesagainsttheeuro,introducedin
1999.
Thepoundandtheyenfloatagainsttheeuro.TheDanishkroneprovidesanexampleof
afixedexchangerate.
Thereisonlyatinyvariationaroundthisrate,nomorethanplusorminus2%.
Thistypeoffixedregimeisknownasaband.

ExchangeRateBehaviour
ExchangeRateBehavior:SelectedDevelopingCountries,19962012

SelectedDevelopingCountries,19962012Exchangeratesindevelopingcountriesshow
awidevarietyofexperiencesandgreatervolatility
Peggingiscommonbutispunctuatedbyperiodiccrises(youcanseetheeffectsofthese
crisesingraphsforThailand,SouthKorea,andIndia)

ExchangeRateBehaviour
ExchangeRateBehavior:SelectedDevelopingCountries,19962012

Argentinaisanexampleofamiddleground,somewherebetweenafixedrateandafree
float,calledamanagedfloat.
Colombiaisanexampleofacrawlingpeg.TheColombianpesoisallowedtocrawl
gradually,itsteadilydepreciatesatanalmostconstantrateforseveralyearsfrom1996to
2002.
Dollarization occurredinEcuadorin2000,whichiswhenacountryunilaterallyadopts
thecurrencyofanothercountry.

ExchangeRateBehaviour
ASpectrumofExchangeRateRegimes

ThisfigureshowsIMFclassificationofexchangerateregimesaroundtheworldforcovers192
economiesin2010.Regimesareorderedfromthemostrigidlyfixedtothemostfreely
floating.Sevencountriesuseanultrahard pegcalledacurrencyboard,while35othershavea
hardpeg.

ExchangeRateBehaviour
ASpectrumofExchangeRateRegimes

Anadditional43countieshavebands,crawlingpegsorbands,while46countrieshave
exchangeratesthateitherfloatfreely,aremanagedfloatsareallowedtofloatwithin
widebands.

AppreciationsandDepreciations
Ifoneunitofonecurrencycanbuymoreof
anothercurrencythanitusedto,wesayithas
experiencedanappreciationitsvaluehas
risen,appreciated,orstrengthened againstthe
othercurrency
Ifacurrencycanbuyslessofanothercurrency,
wesayithasexperiencedadepreciationits
valuehasfallen,depreciated,orweakened

18

AppreciationsandDepreciations
InU.S.terms,thefollowingholdstrue:

WhentheU.S.exchangerateE$/ rises,more
dollarsareneededtobuyoneeuro
Thepriceofoneeurogoesupindollarterms,
andtheU.S.dollarexperiencesadepreciation

WhentheU.S.exchangerateE$/ falls,fewer
dollarsareneededtobuyoneeuro
Thepriceofoneeurogoesdownindollarterms,
andtheU.S.dollarexperiencesanappreciation
19

AppreciationsandDepreciations
Todeterminethesizeofanappreciationordepreciation,we
computetheproportionalchange,asfollows:
In2011,attimet,thedollarvalueoftheeurowas
E$/,t =$1.298.

In2012,attimet+1,thedollarvalueoftheeurowas
E$/,t+1 =$1.318.

Thechangeinthedollarvalueoftheeurowas
E$/,t =1.3181.298=+$0.020.
Thepercentagechangewas
E$/,t/E$/,t =+0.020/1.298=+1.54%.
Thus,theeuroappreciatedagainstthedollarby1.54%.
20

AppreciationsandDepreciations
Similarly,overthesameyear:
In2011,attimet,theeurovalueofthedollarwas
E /$,t =0.770.

In2012,attimet+1,theeurovalueofthedollarwas
E /$,t+1 =0.759.

Thechangeinthedollarvalueoftheeurowas
E /$,t =0.7590.770 =0.011.
Thepercentagechangewas
E/$,t / E/$,t =0.011/0.770=1.43%.
Thus,thedollardepreciatedagainsttheeuroby1.43%.

MultilateralExchangeRates
Multilateral exchangeratechanges arecalculatedby
aggregatingbilateral exchangeratesusingtradeweights
toconstructanaverageovereachcurrencyinthebasket
Theresultingmeasureisthechangeintheeffective
exchangerate.Forexample:
Suppose40%ofHometradeiswithcountry1and60%iswith
country2.Homescurrencyappreciates10%against1but
depreciates30%against2.
TofindthechangeinHomeseffectiveexchangeratebymultiply
eachexchangeratechangebythetradeshareandsum:
(10%40%)+(30%60%)=(0.10.4)+(0.30.6)=

0.04+0.18=0.14=+14%.
Homeseffectiveexchangeratehasdepreciatedby14%.

MultilateralExchangeRates
Ingeneral,supposethereareNcurrenciesinthebasket,
andHomestradewithallNpartnersis:
Trade=Trade1 +Trade2 +...+TradeN.
Applyingtradeweightstoeachbilateralexchangerate
change,thehomecountryseffectiveexchangerate
(Eeffective)willchangeaccordingtothefollowingweighted
average:

Eeffective E1 Trade1 E2 Trade 2

E N Trade N

Eeffective
E Trade
E Trade
E Trade
12N
Trade - weighted average of bilateral nominal exchange rate changes

MultilateralExchangeRates
EffectiveExchangeRates:Change
inValueofU.S.$(20022012)
againsttwodifferentbasketsof
foreigncurrencies

Abasketof7majorcurrencies,
thedollarhaddepreciatedby
35%byearly2008
Againstabroadbasketof26
currencies,thedollarhadlost
only25%by2008

Reasons:$wasfloatingagainst
themajorcurrencies,butthe
broadbasketincludedimportant
U.S.tradingpartners(suchas
China)thatmaintainedfixedor
tightlymanagedexchangerates
againstthedollar

Example:UsingExchangeRatestoComparePricesina
CommonCurrency
UsingtheExchangeRatetoComparePricesinaCommonCurrency Nowpay
attention,007!ThistableshowshowthehypotheticalcostofJamesBondsnext
tuxedoindifferentlocationsdependsontheexchangeratesthatprevail

WhyExchangeRatesMatter
Changesinexchangeratesaffectaneconomyintwo
ways:
Theycauseachangeintheinternationalrelative
pricesofgoods
Onecountrysgoodsandservicesbecomemoreorless
expensiverelativetoanothers

Changesinexchangeratescancauseachangeinthe
internationalrelativepricesofassets
Fluctuationsinwealthcanthenaffectfirms,governments,
andindividuals

WhenExchangeRatesMisbehave
Inanexchangeratecrisisacurrencyexperiencesa
suddenandpronouncedlossofvalueagainst
anothercurrencyfollowingaperiodinwhichthe
exchangeratehadbeenfixedorrelativelystable
Therehavebeenmorethan27exchangeratecrises
inthe12yearperiodfrom1997to2011
Insomecases,includingArgentinain2002,
exchangeratecrisisleadtogovernmentsdeclaring
default (i.e.,asuspensionofpaymentstocreditors)

CurrenciesandCrises
CurrencyCrashes
Thechartshowsthat
exchangeratecrises
arecommonevents
Anexchangeratecrisis
isdefinedasanevent
inwhichacurrency
losesmorethan30%of
itsvalueinU.S.$terms
overoneyear,having
changedbylessthan
20%eachofthe
previoustwoyears

CurrenciesandCrises
Asevereeconomiccrisis
engulfedIcelandin2008,
followingthecollapseofitsE.R.,
afinancialcrisis,anda
governmentfiscalcrisis

ProtestersoutsidetheIcelandicparliamentin
Reykjavikdemandthatthegovernmentdomoreto
improveconditionsfortherecentlypoor.

Realoutputperpersonshrank
bymorethan10%,and
unemploymentrosefrom1%to
9%

Governmentsincrisismayappealforexternalhelpfrom
internationaldevelopmentorganizations,suchasthe
InternationalMonetaryFund(IMF)orWorldBank,orother
countries

TheMarketforForeignExchange
Exchangeratestheworldoveraresetintheforeignexchange
market(orforex orFXmarket).
Theforex marketisnotanorganizedexchange:tradeis
conductedoverthecounter
InApril2010,theglobalforexmarkettraded$4trillionper
dayincurrency
Thethreemajorforeignexchangecentersarelocatedinthe
UnitedKingdom,theUnitedStates,andJapan
OtherimportantcentersforforextradeincludeHongKong,
Paris,Singapore,Sydney,andZurich

TheMarketforForeignExchange:theSpotContract

Thesimplestforextransactionisacontractforthe
immediateexchangeofonecurrencyforanother
betweentwoparties.Thisisknownasaspotcontract
Theexchangerateforthistransactionisoftencalled
the spotexchangerate
Theuseofthetermexchangeratealwaysrefersto
thespotrateforourpurposes
Thespotcontractisthemostcommontypeoftrade
andappearsinalmost90%ofallforextransactions

TheMarketforForeignExchange:Derivatives
Inadditiontospotcontracts,
otherforexcontractsinclude
forwards,swaps,futures,
andoptions
Collectively,alltheserelated
forexcontractsaretermed
derivatives
Thespotandforwardrates
closelytrackeachother

ForeignExchangeDerivatives
Forwards
Aforwardcontractdiffersfromaspotcontractinthatthe
twopartiesmakethecontracttoday,butthesettlement
dateforthedeliveryofthecurrenciesisinthefuture,or
forward.
Thetimetodelivery,ormaturity,varies.
However,becausethepriceisfixedasoftoday,the
contractcarriesnorisk.

ForeignExchangeDerivatives
Swaps
Aswapcontractcombinesaspotsaleofforeigncurrency
withaforwardrepurchaseofthesamecurrency
Thisisacommoncontractforcounterpartiesdealingin
thesamecurrencypairoverandoveragain
Combiningtwotransactionsreducestransactionscosts

ForeignExchangeDerivatives
Derivativesallowinvestorstoengageinhedging(risk
avoidance)andspeculation(risktaking).
Example1: Hedging
AschieffinancialofficerofaU.S.firm,youexpecttoreceive
paymentof1millionin90daysforexportstoFrance
Thecurrentspotrateis$1.20pereuro
Yourfirmwillincurlossesonthedealifthedollarweakensto
lessthan$1.10pereuro
Youadvisethatthefirmbuy1millionincalloptionson
dollarsatarateof$1.15pereuro,ensuringthatthefirms
euroreceiptswillsellforatleastthisrate
Thislocksinaminimalprofitevenifthespotratefallsbelow
$1.15.Thisishedging.

ForeignExchangeDerivatives
Derivativesallowinvestorstoengageinhedging(risk
avoidance)andspeculation(risktaking).
Example2:Speculation
Themarketcurrentlypricesoneyeareurofuturesat$1.30,
butyouthinkthedollarwillweakento$1.43inthenext12
months
Ifyouwishtomakeabet,youwouldbuythesefutures,and
ifyouareprovedright,youwillrealizea10%profit
Anylevelabove$1.30willgenerateaprofit.Ifthedollarisat
orbelow$1.30ayearfromnow,however,yourinvestmentin
futureswillbeatotalloss.Thisisspeculation.

ForeignExchangeActors
PrivateActors
Mostforextradersworkforcommercialbanks. About3/4th of
allforextransactionsgloballyarehandledbyjust10banks
Theexchangeratesforthesetradesunderliequotedmarket
exchangerates
Somecorporationsmaytradeinthemarketiftheyareengaged
inextensivetransactionsinforeignmarkets

GovernmentActions
Somegovernmentsengageinpoliciesthatrestricttrading,
movementofforex,orrestrictcrossborderfinancial
transactionsarecalledaformofcapitalcontrol
Inlieuofcapitalcontrols,thecentralbankmuststandreadyto
buyorsellitsowncurrencytomaintainafixedexchangerate

ArbitrageandSpotExchangeRates

ArbitrageandSpotRatesArbitrageensuresthatthetradeofcurrenciesinNewYork
alongthepathABoccursatthesameexchangerateasviaLondonalongpathACDB.
AtBthepoundsreceivedmustbethesame.RegardlessoftheroutetakentogettoB.
N.Y.
London
E/$
E/$

Arbitragewith3Currencies
Ingeneral,threeoutcomesarepossible

1. Thedirecttradefromdollarstopoundshasabetter
rate:
E/$ >E/ E/$
2. Theindirecttradehasabetterrate:E/$ <E/ E/$
3. Thetwotradeshavethesamerateandyieldthesame
result:E/$ =E/ E/$.Onlyinthelastcasearethereno
profitopportunities.Thisnoarbitragecondition:

E / $

Direct
exchange rate

E / E / $

E /

E$ /

Cross rate

Therighthand
expression,aratioof
twoexchangerates,is
calledacrossrate

ArbitrageandCrossRates

ArbitrageandCrossRatesTriangulararbitrageensuresthatthedirecttradeofcurrencies
alongthepathABoccursatthesameexchangerateasviaathirdcurrencyalongpath
ACB.ThepoundsreceivedatBmustbethesameonbothpaths,and

E / $ E / E / $

CrossRatesandVehicleCurrencies
Themajorityoftheworldscurrenciestradedirectly
withonlyoneortwoofthemajorcurrencies,suchas
thedollar,euro,yen,orpound
Manycountriesdoalotofbusinessinmajor
currenciessuchastheU.S.dollar,soindividuals
alwayshavetheoptiontoengageinatriangulartrade
atthecrossrate
Whenathirdcurrency,suchastheU.S.dollar,isused
inthesetransactions,itiscalledavehiclecurrency
becauseitisnotthehomecurrencyofeitherofthe
partiesinvolvedinthetradeandisjustusedfor
intermediation

ArbitrageandInterestRates
Inwhichcurrencyshouldinvestorholdtheirliquidcash
balances?
Wouldsellingeurodepositsandbuyingdollardepositsmakea
profitforabanker?
Thesedecisionsdrivedemandfordollarsversuseurosandthe
exchangeratebetweenthetwocurrencies
TheProblemofRisk

AtraderinNewYorkcaresaboutreturnsinU.S.dollars.Adollar
depositpaysaknownreturn,indollars.Butaeurodepositpaysa
returnineuro,andoneyearfromnowwecannotknowforsure
whatthedollareuroexchangeratewillbe
Risklessarbitrage andriskyarbitrageleadtotwoimportant
implications,calledparityconditions

$vs depositinvestmentdecision
LetE$/ =spotE.R.USdollar($)andtheeuro()
(numberofunitsof$requiredtopurchase1 )
Aninvestorwantstoinvestanamountx ofdollarsfor
oneyear
Theinvestorconsiderstwooptions:
Abankdepositdenominatedin$inaUSbank,atan
interestratei$
Abankdepositdenominatedin inaEuropeanbank,atan
interestratei

$denominateddeposit:
Theinvestorinvests$x foroneyearinadollardepositin
aUSbankaccount
Attheendoftheyear,indollars,thedepositwillbe
worth
x xi$ (1 i$ ) x

 denominateddeposit:
ThedollarsneedtobeconvertedintoEuro
UsingthespotER,$1buys1/E $/ eurostoday
Thus,theinvestorinvestsx/E$/ (whichisthevalueof
$xin today)intoaeurodenominatedaccountata
interestratei
Attheendoftheyear,ineuro,thedepositwillbeworth

x / E xi
$,

/ E$, (1 i ) x / E$,

Thissumwillhavetobeconvertedbackinto$

Theeurosthenneedtobeconvertedbackinto$,but
thefuturespotrateisnotknownwithcertainty:
exchangeraterisk
Theinvestorcaneitheruse:
Aforwardcontracttoday:makingthefuture
transactionataforwardrateF$/ enablestoavoid
exchangeraterisk
Theexpectedexchangerate (whichimpliesthatthe
investordecidestobeartheexchangeraterisk)

AforwardcontracttodayataforwardrateF$/ enables
toavoidexchangeraterisk
The(1+i )x/E$/ eurosinoneyearstimecanthenbe
exchangedfor(1+i )xF$//E$/ dollars,orthedollar
returnontheeurobankdeposit

(1 i ) x / E$,
Thus,,thedepositin
canbe
convertedbackinto$bymultiplyingfor
either/or

TheforwardexchangerateF$, (iftheinvestor
decidestohedgeagainstexchangeraterisk)
e
E
Theexpectedspotexchangerate F , ,whichisa
forecastandimpliesthattheinvestordecidesto
beartheexchangeraterisk(moreonthislater)

Hence,thedollarvalueoftheinvestmentat
theendoftheyearwillbe:
e
(1 i ) x

F$,

E$,
Eitheror

(1 i ) x

E$,
E$,

 Considerthespecialcaseinwhichtheinvestor
invests$1(i.e.whenx=1)
WheninvestingintheEuropeanbankdeposit,
theinvestorwoulddeposit:1/E$/ and
obtainavalueofinvestmentafteroneyearof:
F$,

(1 i )
Eitheror
E$,

(1 i )

E$,e
E$,

Letsshedsomemorelightonthe
implicationsofthese

RisklessArbitrage:CoveredInterestParity
Threeoutcomesarepossiblewhencomparingthe
dollarreturnsfromthetwodeposits
TheUSdeposithasahigherdollarreturn:advise
banktosellitseurodepositsandbuydollardeposits
TheEurodeposithasahigherdollarreturn:advise
banktosellitsdollardepositsandbuyeurodeposits
Bothdepositshavethesamedollarreturns:no
expectedprofitsfromarbitrage

RisklessArbitrage:CoveredInterestParity
Thenoarbitrageconditionisthen:

1 i$

Dollar return on dollar deposits

F$ /
1 i
E$ /

Dollar return on euro deposits

Thisiscalledcoveredinterestparity(CIP)because
allexchangerateriskontheeurosidehasbeen
coveredbytheuseoftheforwardcontract
Thistypeoftradeemploysforwardcover

RisklessArbitrage:CoveredInterestParity
Coveredinterestparity:NoArbitrageconditionthat
describesanequilibriuminwhichinvestorsare
indifferentbetweenthereturnsoninterestbearingbank
depositsintwocurrenciesandexchangeriskshasbeen
eliminatedbytheuseofaforwardcontract

1 i$

Dollar return on dollar deposits

F$ /
1 i
E$ /

Dollar return on euro deposits

F$/ E$/

1 i$

1 i

RisklessArbitrage:CoveredInterestParity
F$/ E$/

1 i$

1 i

IfCIPholds,wecancalculatetheforwardrateifweknow
allthreerighthandsidevariables:
Thespotrate: E$/
Thedollarinterestrate: i$
Theeurointerestrate: i
Thepriceoftheforwardcontractisderived fromthe
underlyingspotcontractusingadditionalinformationon
exchangerates(hencethenamederivativecontract)

ArbitrageandInterestRates

ArbitrageandCoveredInterestParityUnderCIP,returnstoholdingdollardeposits
accruinginterestgoingalongthepathABmustequalthereturnsfrominvestingineuros
goingalongthepathACDBwithriskremovedbyuseofaforwardcontract.Hence,atB,
therisklesspayoffmustbethesameonbothpaths,and:

F$ /
1 i$
1 i
E$ /

DoesCoveredInterestParityHold?
Returnswillbeequalisedonlyifarbitrageis
possible
Ifgovernmentsimposecapitalcontrols,traders
cannotexploitprofitopportunitiesandthereis
thennoreasonsforthereturnsondifferent
currenciestoequalise
Profitfrommovingfunds,e.g.fromUKto
Germanyseenextgraph(profitiszeroifCIP
hods):
FUK/GER
1 iGER
1 iUK
EUK/GER

EvidenceonCoveredInterestParity
FinancialLiberalizationandCoveredInterestParity

FinancialLiberalizationandCoveredInterestParity:ArbitrageBetweentheUnitedKingdom
andGermanyThechartshowsthedifferenceinmonthlypoundreturnsondepositsinBritish
poundsandGermanmarksusingforwardcoverfrom1970to1995.Inthe1970s,the
differencewaspositiveandoftenlarge:traderswouldhaveprofitedfromarbitragebymoving
moneyfrompounddepositstomarkdeposits,butcapitalcontrolspreventedthemfromfreely
doingso.

EvidenceonCoveredInterestParity
FinancialLiberalizationandCoveredInterestParity

FinancialLiberalizationandCoveredInterestParity:ArbitrageBetweentheUnitedKingdom
andGermany(continued) Afterfinancialliberalization,theseprofitsessentiallyvanished,and
noarbitrageopportunitiesremained.TheCIPconditionheld,asidefromsmalldeviations
resultingfromtransactionscostsandmeasurementerrors.

RisklessArbitrage:UncoveredInterestParity
Thesecondwaytoengageinarbitrageistousespot
contracts,andacceptthatfutureexchangeratesare
subjecttorisk
Thiscasewillenableustounderstandhowexchange
ratesaredeterminedinthespotmarket
Supposeinvestorsfocusonlyontheexpecteddollar
returnofthetwobankdeposits
Inthiscase,tradersfaceexchangerateriskandmust
makeaforecastofthefuturespotrate.
Werefertotheforecastas,whichwecallthe
E$/e
expectedexchangerate

RisklessArbitrage:UncoveredInterestParity
(1 i ) / E$/
Basedontheforecast,youexpectthatthe
eurosyouwillhaveinoneyearstimewillbeworth
(1 i ) E$/e / E$/ whenconvertedintodollars
Thisistheexpecteddollarreturn oneurodeposits
(i.e.theexpecteddollarvalueofprincipaland
interestforeurodeposits)

RisklessArbitrage:UncoveredInterestParity
Threeoutcomesarepossible
TheUSdeposithasahigherexpecteddollarreturn
TheEurodeposithasahigherexpecteddollarreturn
Bothdepositshavethesamehigherexpecteddollarreturn

Inthefirsttwocasesthereareexpectedprofit
opportunitiesandriskyarbitrage ispossible(selllow
expectedreturnsdepositandbuyhighexpectedreturn
deposit)
Thenoarbitrageconditionoruncoveredinterestparity
(UIP)is:
E$e/

1 i$ 1 i

E$ /
Dollar return on

dollar deposits

Expected dollar return

on euro deposits

RisklessArbitrage:UncoveredInterestParity
Uncoveredinterestparity(UIP)
E$e/

1 i$ 1 i

E /
Dollar return on
$
dollar deposits

Expected dollar return

on euro deposits

Exchangerateriskhasbeenleftuncovered bythe
decisionnottohedgeagainstexchangerateriskby
usingaforwardcontract
Instead,theinvestorissimplywaitingtouseaspot
contractinayearstime

RisklessArbitrage:UncoveredInterestParity

ArbitrageandUncoveredInterestParityUnderCIP,returnstoholdingdollardeposits
accruinginterestgoingalongthepathABmustequalreturnsfrominvestingineuros
goingalongtheriskypathACDB.Hence,atB,theexpectedpayoffmustbethesameon
bothpaths,and
e

E$ /
1 i$
1 i
E$ /

ArbitrageandInterestRates:
WhatDeterminestheSpotRate?
Uncoveredinterestparityisanoarbitrageconditionthat
describesanequilibriuminwhichinvestorsareindifferent
betweenthereturnsonunhedgedinterestbearingbank
depositsintwocurrencies.
Wecanrearrangethetermsintheuncoveredinterestparity
expressiontosolveforthespotrate:

E$ / E

e
$/

1 i
1 i$

AssetsandTheirAttributes
Aninvestorsentireportfolioofassetsmayincludestocks,bonds,
realestate,art,bankdepositsinvariouscurrencies,andsoon.
Allassetshavethreekeyattributesthatinfluencedemand:
return,risk,andliquidity
Anassetsrateofreturnisthetotalnetincreaseinwealth
resultingfromholdingtheassetforaspecifiedperiodoftime,
typicallyoneyear
Theriskofanassetreferstothevolatilityofitsrateofreturn
Theliquidityofanassetreferstotheeaseandspeedwithwhich
itcanbeliquidated,orsold
Werefertotheforecastoftherateofreturnastheexpected
rateofreturn.

EvidenceonUncoveredInterestParity
DoestheUncoveredInterestParity(UIP)hold?
Thetwointerestparityequationsareverysimilar
TheCIPequationsusestheforwardrate
TheUIPequationusestheexpectedfuturespotrate
CIP :
UIP :

DividingtheUIPbythe
CIP,weobtain:

F$/

1
i
1
i
$
E$/
e
$/

E
1 i$ 1 i
E$/

E$/e
1
F$/ E$/e
F$/

EvidenceonUncoveredInterestParity
Thus,inequilibrium:

E$e/ F$ /

Althoughtheexpectedfuturespotrateandtheforwardrate
areusedintwodifferentformsofarbitrageriskyand
riskless,inequilibriumtheyshouldbeexactlythesame!
Ifbothcoveredinterestparityanduncoveredinterestparity
hold,theforwardmustequaltheexpectedfuturespotrate
Ifinvestorsdonocareaboutriskhavenoreasontopreferto
avoidriskbyusingtheforwardrate,ortoembraceriskby
awaitingthefuturespotrate

EvidenceonUncoveredInterestParity
Iftheforwardrateequalstheexpectedspotrate,the
expectedrateofdepreciationequalstheforward
premium(theproportionaldifferencebetweenthe
forwardandspotrates):

F$ /
1
E$ /

Forward premium

e
$/

E
1
E$ /

Expected rate of depreciation

Whilethelefthandsideiseasilyobserved,the
expectationsontherighthandsidearetypically
unobserved

EvidenceonUncoveredInterestParity
EvidenceonInterestParity
WhenUIPandCIPhold,the
12monthforwardpremium
shouldequalthe12month
expectedrateof
depreciation.Ascatterplot
showingthesetwovariables
shouldbeclosetothe
diagonal45degreeline.
Usingevidencefromsurveys
ofindividualforextraders
expectationsovertheperiod
1988to1993,UIPfindssome
support,asthelineofbestfit
isclosetothediagonal.

UncoveredInterestParity:AUsefulApproximation
Holdingdollardepositsrewardstheinvestorwithdollarinterest
Holdingeurodepositsrewardstheinvestorsineurointerest.In
addition,theyreceiveagain(orloss)ineuroequaltotherateof
euroappreciation(ordepreciation) thatapproximatestherate
ofdollardepreciation(ordepreciation)
FortheUIP tohold(whichmakestheinvestorindifferent
betweendollarandeurodeposits),aninterestshortfallonthe
eurodepositmustbeoffsetbyanexpectedgainintheformof
euroappreciationagainstthedollar
(oraninterestexcessontheeurodepositmustbeoffsetbyan
expectedlossintheformofeurodepreciationagainstthe
dollar)

UncoveredInterestParity:AUsefulApproximation
Thus:
i$

Interest rate
on dollar deposits
=
Dollar rate of return
on dollar deposits

Interest rate
on euro deposits

E$e/
E$ /

Expected rate of depreciation

of the dollar

Expected dollar rate of return

on euro deposits

TheUIP approximationequationsaysthatthehomeinterest
rateequalstheforeigninterestrateplustheexpectedrateof
depreciationofthehomecurrency
Supposethedollarinterestrateis4%peryearandtheeuro3%.
IfUIPistohold,theexpectedrateofdollardepreciationovera
yearmustbe1%.Thetotaldollarreturnontheeurodepositis
approximatelyequaltothe4%thatisofferedbydollardeposits

ArbitrageandInterestRates:Summary

HowInterestParityRelationshipsExplainSpotandForwardRatesInthespotmarket,
UIPprovidesamodelofhowthespotexchangerateisdetermined.TouseUIPtofind
thespotrate,weneedtoknowtheexpectedfuturespotrateandtheprevailing
interestratesforthetwocurrencies.

ArbitrageandInterestRates:Summary

HowInterestParityRelationshipsExplainSpotandForwardRatesIntheforward
market,CIPprovidesamodelofhowtheforwardexchangerateisdetermined.When
weuseCIP,wederivetheforwardratefromthecurrentspotrate(fromUIP)andthe
interestratesforthetwocurrencies.

Conclusions
1. TheE.R.inacountryisthepriceofaunitofforeign
currencyexpressedintermsofthehomecurrency.
Thispriceisdeterminedinthespotmarketfor
foreignexchange.
2. WhenthehomeE.R.rises,lessforeigncurrencyis
bought/soldperunitofhomecurrency;thehome
currencyhasdepreciated.Ifhomecurrencybuys
x%lessforeigncurrency,thehomecurrencyissaid
tohavedepreciatedbyx%.

Conclusions
3. WhenthehomeE.R.falls,moreforeigncurrencyis
bought/soldperunitofhomecurrency;thehome
currencyhasappreciated.Ifhomecurrencybuys
x%moreforeigncurrency,thehomecurrencyis
saidtohaveappreciatedbyx%.
4. TheE.R.isusedtoconvertthepricesofgoodsand
assetsintoacommoncurrencytoallowmeaningful
pricecomparisons

Conclusions
5. ExchangeRatesmaybestableovertimeorthey
mayfluctuate.Historysuppliesexamplesofthe
former(fixedE.R.regimes)andthelatter(floating
E.R.regimes)aswellasanumberofintermediate
regimetypes
5. Anexchangeratecrisisoccurswhentheexchange
rateexperiencesasuddenandlargedepreciation.
Theseeventsareoftenassociatedwithbroader
economicandpoliticalturmoil,especiallyin
developingcountries

Conclusions
7. Somecountriesmayforgoanationalcurrencyto
formacurrencyunionwithothernations(e.g.,the
Eurozone),ortheymayunilaterallyadoptthe
currencyofanothercountry(dollarization).
8. Lookingacrossallcountriestoday,numerousfixed
andfloatingrateregimesareobserved,sowemust
understandbothtypesofregime.

Conclusions
9. Theforexmarketisdominatedbyspottransactions,
butmanyderivativecontractsexist,suchas
forwards,swaps,futures,andoptions.
10.Themainactorsinthemarketareprivateinvestors
and(frequently)thegovernmentauthorities,
representedusuallybytheCentralBank.

Conclusions
11. ArbitrageoncurrenciesmeansthatspotE.R.are
approximatelyequalindifferentforexmarkets.
Crossrates(forindirecttrades)andspotrates(for
directtrades)arealsoapproximatelyequal.
12. Risklessinterestarbitrageleadstothecovered
interestparity(CIP)condition.CIPsaysthatthe
dollarreturnondollardepositsmustequalthe
dollarreturnoneurodeposits,whereforward
contractsareusedtocoverexchangeraterisk.

Conclusions
13.Coveredinterestparitysaysthattheforwardrateis
determinedbyhomeandforeigninterestratesandthe
spotexchangerate.
14.Riskyinterestarbitrageleadstotheuncoveredinterest
parity(UIP)condition.UIPsaysthatwhenspotcontracts
areusedandexchangerateriskisnotcovered,thedollar
returnondollardepositsmustequaltheexpecteddollar
returnsoneurodeposits.
15.Uncoveredinterestparityexplainshowthespotrateis
determinedbythehomeandforeigninterestratesand
theexpectedfuturespotexchangerate.

Reading
Feenstra R.andA.M.Taylor (2014)International
Economics,WorthPublishers,Macmillan,Chapters
12and13