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Topic 5:
Covered Interest
Rate Parity
Hence
(1+i)/(1+i*) = F/S
(F-S)/S=(i-i*)/(1+i*)
Default risk
Counterparty may fail to honor its contract
Let p be default probability: (1-p)(1+i)
If different banks have different risk, then differ
interest rate might just reflect credit risk
Exchange controls
Limitations, taxes
See example 6.5
Political risk
SNB scraps fixed exchange rate
Speculation and
Risk in the
Foreign Exchange
Market
adapted by Uwe Walz
Slides prepared by
6-21
Excess
return
(t+1)
=
S(t+1)
*
(7M/$10M)
1.08
2012 Pearson Education, Inc. All rights reserved. 21
Speculating in the Foreign Exchange Market
fmr(t+1) * [1+i()] =
[S(t+1)/S(t)]*[1+i()]-[1+i($)] = exr(t+1)
Forecast error
the difference between the actual future spot exchange
rate and its forecast
Unbiased predictors
implies expected forecast error = 0
Can have large errors as long as they dont favor one side
The unbiasedness hypothesis and market efficiency
If the forward rate were biased then one side or the other
of a bet (i.e., futures contract) would be expected the win
and none would volunteer to be the other side of that bet
Consistency problem if unbiased from perspective of,
its biased in the other direction, i.e., $/
Main findings
High-interest-rate currencies depreciate
Forward premium on a foreign currency =
interest differential between the two
currencies
Failure to reject the unbiasedness hypothesis
with the test of conditional mean
Alternative view
Unbiasedness should be rejected
Uncovered IRP is risky
Risk averse investors should be compensated
Types of risks:
Unsystematic (Idiosyncratic) risk the risk that is attributed to
the individual asset and can be diversified away
Systematic risk the risk associated with an assets return
arising from the covariance of the return with the return on a
large, well-diversified portfolio
Costs of hedging
If premium exists, then hedging may be costly
99.17 100
4 = 3.32%
100
Purchasing Power
Parity and Real
Exchange Rates
Inflation/deflation
Inflation when price level is rising
Deflation when price level is falling
PPP P(h)
S (h / f ) =
P( f )
Overview
Changes in relative prices what if Japanese spend
more on sushi than Americans do?
Different weights
Non-traded goods
Houses
Technology/productivity improvements
PPP deviations and the Balance of Payments
When a currency is overvalued (relative to that implied
by the PPP), the external purchasing power increases
and consumers buy more foreign goods, thus pulling the
value of the domestic currency back down