Chapter 11 Market Efficiency, Uncovered Interest Parity and Real Interest Parity
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 2 Objectives To explain the concept of market efficiency. To describe the UIP condition. To assess the empirical validity of UIP. To explain the concept of the real interest rate and derive real interest parity (RIP).
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 3 The Concept of Market Efficiency A distinction is made between allocative efficiency and informational efficiency. In an efficient market, prices reflect all available information.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 4 Implications It is not possible to predict price movements from available information. It is not possible to earn abnormal returns via active trading.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 5 Weak Efficiency Prices reflect all the information contained in the past behaviour of prices.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 6 Semi-Strong Efficiency Prices reflect all the information contained in their past behaviour, as well as all public information.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 7 Strong Efficiency Prices reflect all available information, including private and insider information.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 8 Spot-Market Efficiency The spot exchange rate moves in a random and unpredictable way, reflecting the random arrival of new information:
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 9 Forward Market Efficiency The market reflects all available information where the information is contained in the forward rate.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 10 Forward Market Efficiency (cont.)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 11 The Forward Rate as Predictor of the Spot Rate (AUD/GBP)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 12 The Forecasting Error of the Forward Rate (AUD/GBP)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 13 Uncovered Interest Parity UIP is a condition that precludes profitable uncovered arbitrage. It is ‘uncovered’ because the long currency position is left open. It can be derived by combining CIP and unbiased efficiency.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 14 Return on Domestic Investment and Foreign Investment (with Uncovered Position) Converting at spot rate Investing in foreign assets Reconverting at expected spot rate Domestic Investment Foreign Investment Investor (K)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 15 The UIP Condition
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 16 The Effect of Uncovered Arbitrage UIP can be derived from arbitrage. A violation of the UIP condition triggers uncovered arbitrage.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 17 Uncovered Interest Arbitrage Covered margin Investing at domestic rate Domestic foreign Borrowing domestic currency Converting at spot rate Investing at foreign rate Foreign domestic Borrowing foreign currency Converting at spot rate S 1 unit Reconverting at spot rate Loan repayment Covered margin 1 unit Reconverting at spot rate
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 18 Uncovered Arbitrage with Bid-Offer Spreads Covered margin Investing at domestic bid rate Domestic foreign Borrowing domestic currency Converting at spot offer rate Investing at foreign bid rate Foreign domestic Borrowing foreign currency Converting at spot bid rate S 1 unit Reconverting at spot bid rate Loan repayment Covered margin 1 unit Reconverting at spot offer rate
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 19 The Empirical Validity of UIP For UIP to be valid, the uncovered margin must fluctuate around a mean value of zero.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 20 Uncovered Margins in Percentage Points (Short Australian Dollar)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 21 Uncovered Margins in Percentage Points (Short Australian Dollar) (cont.)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 22 Uncovered Margins in Percentage Points (Short Australian Dollar) (cont.)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 23 Uncovered Margins in Percentage Points (Short Australian Dollar) (cont.)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 24 Real Interest Parity The real interest rate is the nominal rate adjusted for inflation
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 25 Real Interest Parity RIP can be derived by combining UIP and PPP.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 26 Splitting the Real Interest Differential