Chapter 6Exchange Rates, Interest Rates, and Interest Rate ParityChapter 6Exchange Rates, InterTopics to be CoveredInterestRateParity:Exchangerate,InterestrateFisherEquation:ExchangeRates,InterestRates,andInflationExpectedExchangeRateandtheTermStructureofInterestRateTopics to be CoveredInterest RNews from the EconomistHot and botheredDespitestrictcapitalcontrols,Chinaisbeingfloodedbythebiggestwaveofspeculativecapitalevertohitanemergingeconomy.Jun26th2008|BEIJINGNews from the EconomistHot andIn2007-2008,interestratesinChinaandtheUnitedStateshavebeenmovinginoppositedirections.TheU.S.FederalReserveloweredthefederalfundsrateninetimesfromahighof5.25%inJune2007to2.00%.Overthesametimeperiod,thePeoplesBankofChinaraiseditsbenchmarkone-yearinterestrateondepositsfrom2.52%to4.14%.In 2007-2008, interest rates iInadditiontotheattractionoftheinterestratedifference,speculatorsaremoving“hotmoney”intoChinabecauseofthegeneralexpectationthattheRMBwillcontinueappreciateinvalueagainsttheU.S.dollarandothercurrencies.SinceJuly21,2005,throughJuly15,2008,theRMBhasappreciatedinvalueby21.6%.MostanalystsexpecttheChinesegovernmenttocontinuetheRMBsappreciation.In addition to the attraction Covered Interest Rate Arbitrage Consider the following set of foreign and domestic interest rates and spot and forward exchange rates.Covered Interest Rate ArbitragCovered Interest Rate ArbitrageAtraderwith$1,000toinvestcouldinvestintheU.S,inoneyearhisinvestmentwillbeworth$1,050=$1,000 (1+i$)=$1,000 (1.05)Alternatively,thistradercouldexchange$1,000for800attheprevailingspotrate,(notethat800=$1,000$1.25/)invest800ati=10%foroneyeartoachieve880.Translate880backintodollarsatF360($/)=$1.30/,the880willbeexactly$1,144.SoWhatwouldhappenifeveryonerecognizethearbitrageopportunity?Covered Interest Rate ArbitragMoreandmorepeoplewouldexchange$toatthespotmarket,sothespotexchangerateofPoundwouldappreciate.Atthesametime,Moreandmorepeoplewouldexchangeto$attheforwardmarket,thustheforwardexchangerateofPoundwoulddepreciate.Moreoveratthemoneymarket,moreandmorepeoplewouldborrowmoneyfromUSdollarmarketandlendittothePoundmarket,theni$wouldincreaseandiwoulddecreaserespectively. More and more people wouldInpractice,intheshorttermtheresponseofFEMismuchfasterthanthatofmoneymarket,sowecanhavetheInterestRateParity. In practice, in the short Interest Rate ParityThe interest rate parity relationship is a result of profit-seeking arbitrage activity called covered interest rate arbitrage (无风险套利、抵补套利无风险套利、抵补套利).A U.S. investor deciding between investing in the U.S. or in the U.K. must consider:The interest rates, i$ and iThe spot exchange rate, E , (in $/ )The forward exchange rate, F, (in $/ )Interest Rate ParityThe intereInterest Rate Parity (cont.)By investing $1 at home, the U.S. investor can earn 1 + i$ for one period. Or, since $1 = 1/E pounds, the U.S. investor can invest in the U.K. and earn (1 + i)/E.Since future spot rates are unknown, the investor can eliminate the uncertainty over the future dollar value of the investment with a forward exchange contract.Interest Rate Parity (cont.)ByCovered Return（抵补收益）（抵补收益）Covered return is the domestic currency value of a foreign investment when the foreign currency proceeds are sold in the forward market.In our example, the covered return is equal to (1 + i)F/E dollars. Arbitrage between the two investment opportunities results in: （6.1）Covered Return（抵补收益）Covered reInterest Rate Parity Interest rate parity states that the forward premium (or discount) is equal to the interest rate differential between two currencies. This parity is approximated by the equation: （6.3）Interest Rate Parity Interest Effective Return (有效收益有效收益) The effective return on a foreign investment is given by the interest rate plus the expected change in the exchange rate. Using our example, the effective return is:（6.4）Effective Return (有效收益) The efReasons Why Interest Rate Parity May Not HoldBuyingandsellingforeignexchangeandinternationalsecuritiesinvolvetransactioncosts.Taxesmaydifferaccordingtoaninvestorsresidence.Governmentcontrolsonfinancialcapitalflowsmayexist.Theremaybepoliticalrisks.Reasons Why Interest Rate PariInterest Rates and InflationNominal Interest Ratethe interest rate actually observed in the market.Real Interest Ratethe nominal interest rate minus or adjusted for inflation.Interest Rates and InflationNoFisher EquationThe relationship between interest rates and inflation is given by the Fisher equation: where i is the nominal interest rate, r is the real interest rate, and is the expected rate of inflation. Refer to Table 6.1（5.5）Fisher EquationThe relationshiTABLE 6.1 Interest Rates and Inflation Rates for Selected Countries, 20071TABLE 6.1 Interest Rates and Exchange Rates, Interest Rates, and InflationIftherealinterestratesareequalizedinternationally,InterestRateParityindicates(GivenourU.S.andU.K.investmentexample):（6.7）Exchange Rates, Interest RatesTerm Structure（期限结构）（期限结构） of Interest RatesFordifferentinvestmentopportunitiesandfordifferentmaturitydates,theinterestratesvary.Termstructureofinterestratesthepatternofinterestratesoverdifferenttermsofmaturitydates.Term Structure（期限结构） of Intere1.Expectationlongterminterestratetendstobeequaltoanaverageofshorttermratesexpectedoverthelongtermholdingperiod.2.Liquiditypremiumriskpremium（Peopleprefertolendshortterm）3.PreferredhabitatTherearedifferentmarketsforlongtermandshortterminterestrate.Theinterestratesaredeterminedbysupplyanddemandineachmarket.1. Expectation long term int国际金融(双语)chap6课件Expected Exchange Rates and Term Structure of Interest RatesRefertoFigure6.1EurocurrencyInterestRatesIfthetermstructurelinesfortwocountriesare:Parallel,thenthefuturechangesinexchangerateareexpectedtobeconstantDiverging,thenthehigh-interest-ratecurrencyisexpectedtodepreciateatanincreasingrateovertimeConverging,thenthehigh-interest-ratecurrencyisexpectedtodepreciateatadecliningraterelativetothelow-interest-ratecurrencyp123Expected Exchange Rates and TeSuppose the term structure of interest rates is rising for the United States and falling for Japan. If this is all you know, what can you say about the expected change in the yen/dollar exchange rate?As we move out over time, the expected change in the exchange rate should increase.Suppose the term structure of ExerciseThe 1-year interest rate on Swiss francs is 5 percent, and the dollar interest rate is 8 percent.a.If the current $/SF spot rate is $0.60, what would you expect the spot rate to be in 1 year?b.Why is there no observable expected future spot rate?c.Suppose U.S. policy changes and leads to an expected future spot rate of $0.63. What would you expect the dollar interest rate to be now? (Assume no change in the Swiss interest rate.)ExerciseThe 1-year interest raa. 1.08=1.05+(F-0.60)/0.60, F=0.618b. The reasons of why IRP may not holdc. i$ = (0.63-0.60)/0.60+.05 = 0.10 percenta.1.08=1.05+(F-0.60)/0.60, F=ThoughtIndicate whether the following quotation is true or false, and then carefully explain your answer. “Lenders benefit from unexpected inflation but borrowers are hurt by it.”ThoughtIndicate whether the foSuppose there is no inflation, and I loan you $100 for a year at 5%. But suddenly the money supply zooms, and the inflation rate turns out to be 10% over the year, and on the day you pay me back the $105, it now takes $110 to buy what $100 used to. The $105 wont even be worth what $100 was worth a year ago, and I am clearly worse off for having loaned you the money. Ive receiveda nominal interest rate of 5% but a real interest rate of -5%. You, on the other hand, had to pay me back less than you borrowed in real terms. Lenders are hurt from unexpected inflation, but borrowers benefit from it.Suppose there is no inflation,QuestionAssume the 3-month interest differential for Swiss francs minus British pounds is equal to -0.05. The 6-month interest differential is equal to -0.03. Is the British pound selling at a premium or a discount relative to the Swiss franc? How is the expected rate of pound appreciation or depreciation changing over time?QuestionAssume the 3-month intSince British interest rates are higher than Swiss rates, IRP requires that the pound will sell at a forward discount against the franc. With the forward rate lower than the spot rate. The rate of such depreciation is expected to depreciate at a declining rate relative to the low-interest-rate currency.Since British interest rates a