Exchange Rates and Interest Rates

Interest Parity

PPP and IP

Relationship between exchange rates and

prices ------ Purchasing Power Parity
PPP is expected to hold when there is no
arbitrage opportunity in goods markets.
Relationship between exchange rates and
interest rates ------ Interest Parity
IP is expected to hold when there is no
arbitrage opportunity in financial markets.

PPP and IP

Financial- asset prices adjust to new

information more quickly than goods
prices PPP does not hold in the short
run

Interest Parity

1/30/02 FT
US$ Libor (3 months): 1.870 = i$
Euro Libor (3 months): 3.351 = i
Euro spot: 0.8617 = E$/
Euro 3 months forward: 0.8585 = F$/

Euro currency

Offshore Banking
Euro dollar, Euro yen
Euro banks
Libor = London Interbank Offer Rate

Interest Parity

By investing $1,000 for 3 months, an

investor in the US can earn 1,000 x (1+i$)
= 1,000 x [1+(0.018704)] = 1,004.67
dollars at home.
Alternatively, she can invest in the EU by
converting dollars to euros and then
investing the euros.

Interest Parity

$1,000 equal to 1,000 E$/ = 1,000

0.8617 = 1,160.50 euros, which is the
quantity of euros resulting from the 1,000
dollars invested.
After three months, she will receive
1,160.50 x (1+i) = 1,160.50 x [1+(0.03351
4)] = 1,170.22 euros.

Interest Parity

She will have to convert this investment

return to dollars at the exchange rate that
will prevail 3 months later, which is
unknown today.
To avoid this uncertainty, she can cover
the investment in euro with a forward
contract.

Interest Parity

She sells 1,170.22 to be received in 3

months in the forward market today.
The covered return is (1,000 E$/) x
(1+i) x F$/ = 1,170.22 x F$/ = 1,170.22 x
0.8585 = 1,004.64 dollars, which is pretty
close to $1,004.67.

Interest Parity

Arbitrage makes the difference between

the returns on two investment
opportunities equal to zero.
In other words,
1+i$ = (1+i)(F$/ /E$/)
or
(1+i$)/ (1+i) = (F$/ /E$/)

Interest Parity

Interest rate parity condition is given by

(i$-i)/ (1+i) = (F$/-E$/) /E$/
which is approximated by
i$-i = (F$/-E$/) /E$/ (Covered Interest
Parity)

In other words, the interest differential between

the US and the EU is equal to the forward
premium of the euro.

Interest Parity

To check CIP:
(i$-i) = (1.870 3.351)400 = -0.0037
(F$/-E$/) /E$/ = (0.8585 0.8617)0.8617
= -0.0037
CIP can be rewritten as
i$ =i + (forward premium)
where (forward premium) = (F$/-E$/) /E$/

Uncovered Interest Parity

Suppose that a US investor is buying a UK

bond without using the forward market.
The 6 months Libor is 4.17250 %, but
this is not the rate of return relevant for the
US investor.

UIP

The effective rate is given by

i + (Ee$/-E$/) /E$/
= (UK interest rate) + (Expected rate of
depreciation)
where Ee$/ stands for the expected
exchange rate 3 month ahead.

UIP

In other words, the expected return on a

pound investment is the UK interest rate
plus the expected rate of depreciation of
the dollar against the pound.

UIP: an example

Suppose an investor expects the dollar to

appreciate by 1.15% over six months.
Then, the expected return on a UK bond is
(4.172502) 1.15 = 0.936 %.
This is almost same as the return on a US
bond: 1.8702 = 0.935 %.
In such a case, we say that Uncovered
Interest Parity holds.

Inflation and Interest Rates

Nominal interest rate = i : the observed

rate
Real interest rate = r : the rate adjusted
for inflation

Fisher Effect

Nobody lends someone money at 5%

interest rate when the inflation rate is
expected to be 6% for the next year.
(Why?)
The nominal interest rate incorporates
inflation expectations to provide lenders
enough level of real return. Fisher Effect

Fisher Equation

i = r + e
where e = expected rate of inflation
Higher the inflation expectations, higher
will be the nominal interest rates.
The interest rates were high in 1970s and
80s.

Exchange rates, interest rates

and inflation

Fisher equations for two countries:

i$ = r$ + USe
i = r + Je
If the real rate is the same between two
countries, that is, r$ = r , then

i$ - i = USe - Je = (F$/-E$/) /E$/

CIP, PPP, and FE

Covered Interest Parity:

i$ - i = (F$/-E$/) /E$/
Relative PPP:
USe - Je = % E$/ = (F$/-E$/) /E$/
Fisher equations for two countries:
i$ = r$ + USe
i = r + Je
CIP + Relative PPP + FE implies r$ = r

Implications

Suppose initially CIP holds:

i$ - i = (F$/-E$/) /E$/
Suppose further that the Democrats take
over the senate and congress and start
massive spending.
Then, USe . (Why?)
This implies i$ by Fisher equation
(Why?)

Three possible cases

1.

2.

3.

Possibly, Ee . Then F . (Why?)

More likely, Ee does not change. Then E .
(Why?)
Suppose that the US or Japan or both
intervene the FX markets, trying to keep the
exchange rate constant. Then, there will be no
change in i$ - i (Why?)
But i$ (Why?)
So, i has to go up.
Then, J will also go up. (Why?)

Expected exchange rate and the

Term Structure of Interest Rates

How different are the interest rates for

different maturities? Term Structure of
Interest Rates
In bonds market, there are 3-month, 6month, 1-year, 3-year, 10-year, and 30year bonds.
Short-term, medium-term, long-term
interest rates.

Term Structure of Interest Rates

Expectations Hypothesis:
The expected return from the long-term bond
tends to be equal to the return generated from
holding the series of short-term bonds.
Liquidity Premium
Risk-averse investors more prefer lending
short-term than long-term. (Why?)
Long-term bonds incorporate a risk-premium.