1. 宁波工程学院国商教研室蒋力编 Chapter 6 Exchange Rates, Interest Rates, and Interest Rate Parity

2. 5-2 宁波工程学院国商教研室蒋力编 Topics to be Covered Interest Rate Parity: Exchange rate, Interest rate Fisher Equation: Exchange Rates, Interest Rates, and Inflation Expected Exchange Rate and the Term Structure of Interest Rate

3. 5-3 宁波工程学院国商教研室蒋力编 News from the Economist Hot and bothered Despite strict capital controls, China is being flooded by the biggest wave of speculative capital ever to hit an emerging economy. Jun 26th 2008 | BEIJING

4. 5-4 宁波工程学院国商教研室蒋力编 In 2007-2008, interest rates in China and the United States have been moving in opposite directions. The U.S. Federal Reserve lowered the federal funds rate nine times from a high of 5.25% in June 2007 to 2.00%. Over the same time period, the People’s Bank of China raised its benchmark one-year interest rate on deposits from 2.52% to 4.14%.

5. 5-5 宁波工程学院国商教研室蒋力编 In addition to the attraction of the interest rate difference, speculators are moving “hot money” into China because of the general expectation that the RMB will continue appreciate in value against the U.S. dollar and other currencies. Since July 21, 2005, through July 15, 2008, the RMB has appreciated in value by 21.6%. Most analysts expect the Chinese government to continue the RMB’s appreciation.

6. 5-6 宁波工程学院国商教研室蒋力编 Covered Interest Rate Arbitrage Consider the following set of foreign and domestic interest rates and spot and forward exchange rates. Spot exchange rateS($/£)=$1.25 360-day forward rateF 360 ($/£)=$1.30 U.S. discount ratei$i$ =5% British discount rate i£ i£ =10%

7. 5-7 宁波工程学院国商教研室蒋力编 Covered Interest Rate Arbitrage A trader with $1,000 to invest could invest in the U.S, in one year his investment will be worth $1,050 = $1,000  (1+ i $ ) = $1,000  (1.05) Alternatively, this trader could exchange $1,000 for £800 at the prevailing spot rate, (note that £800 = $1,000÷$1.25/£) invest £800 at i £ = 10% for one year to achieve £880. Translate £880 back into dollars at F 360 ($/£) = $1.30/£, the £880 will be exactly $1,144. So What would happen if everyone recognize the arbitrage opportunity?

8. 5-8 宁波工程学院国商教研室蒋力编 More and more people would exchange $ to £ at the spot market, so the spot exchange rate of Pound would appreciate. At the same time, More and more people would exchange £ to $ at the forward market, thus the forward exchange rate of Pound would depreciate. Moreover at the money market, more and more people would borrow money from US dollar market and lend it to the Pound market, then i $ would increase and i £ would decrease respectively.

9. 5-9 宁波工程学院国商教研室蒋力编 In practice, in the short term the response of FEM is much faster than that of money market, so we can have the Interest Rate Parity.

10. 5-10 宁波工程学院国商教研室蒋力编 Interest Rate Parity The 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 ). A U.S. investor deciding between investing in the U.S. or in the U.K. must consider: –The interest rates, i $ and i £ –The spot exchange rate, E, (in $/ £) –The forward exchange rate, F, (in $/ £)

11. 5-11 宁波工程学院国商教研室蒋力编 Interest 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.

12. 5-12 宁波工程学院国商教研室蒋力编 Covered Return （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 ）

13. 5-13 宁波工程学院国商教研室蒋力编 Interest 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 ）

14. 5-14 宁波工程学院国商教研室蒋力编 Effective Return ( 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 ）

15. 5-15 宁波工程学院国商教研室蒋力编 Reasons Why Interest Rate Parity May Not Hold Buying and selling foreign exchange and international securities involve transaction costs. Taxes may differ according to an investor’s residence. Government controls on financial capital flows may exist. There may be political risks.

16. 5-16 宁波工程学院国商教研室蒋力编 Interest Rates and Inflation Nominal Interest Rate—the interest rate actually observed in the market. Real Interest Rate—the nominal interest rate minus or adjusted for inflation.

17. 5-17 宁波工程学院国商教研室蒋力编 Fisher Equation The 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 π is the expected rate of inflation. Refer to Table 6.1 （ 5.5 ）

18. 5-18 宁波工程学院国商教研室蒋力编 TABLE 6.1 Interest Rates and Inflation Rates for Selected Countries, 2007 1

19. 5-19 宁波工程学院国商教研室蒋力编 Exchange Rates, Interest Rates, and Inflation If the real interest rates are equalized internationally, Interest Rate Parity indicates (Given our U.S. and U.K. investment example): （ 6.7 ）

20. 5-20 宁波工程学院国商教研室蒋力编 Term Structure （期限结构） of Interest Rates For different investment opportunities and for different maturity dates, the interest rates vary. Term structure of interest rates—the pattern of interest rates over different terms of maturity dates.

21. 5-21 宁波工程学院国商教研室蒋力编 1. Expectation – long term interest rate tends to be equal to an average of short term rates expected over the long term holding period. 2. Liquidity premium – risk premium （ People prefer to lend short term ） 3. Preferred habitat – There are different markets for long term and short term interest rate. The interest rates are determined by supply and demand in each market.

22. 5-22 宁波工程学院国商教研室蒋力编

23. 5-23 宁波工程学院国商教研室蒋力编 Expected Exchange Rates and Term Structure of Interest Rates Refer to Figure 6.1 Eurocurrency Interest Rates If the term structure lines for two countries are: –Parallel, then the future changes in exchange rate are expected to be constant –Diverging, then the high-interest-rate currency is expected to depreciate at an increasing rate over time –Converging, then the high-interest-rate currency is expected to depreciate at a declining rate relative to the low-interest- rate currency –p123

24. 5-24 宁波工程学院国商教研室蒋力编 Suppose 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.

25. 5-25 宁波工程学院国商教研室蒋力编 Exercise The 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.)

26. 5-26 宁波工程学院国商教研室蒋力编 a.1.08=1.05+(F-0.60)/0.60, F=0.618 b.The reasons of why IRP may not hold c.i$ = (0.63-0.60)/0.60+.05 = 0.10 percent

27. 5-27 宁波工程学院国商教研室蒋力编 Thought Indicate 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.”

28. 5-28 宁波工程学院国商教研室蒋力编 Suppose 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 won’t even be worth what $100 was worth a year ago, and I am clearly worse off for having loaned you the money. I’ve 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.

29. 5-29 宁波工程学院国商教研室蒋力编 Question Assume 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?

30. 5-30 宁波工程学院国商教研室蒋力编 Since 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.