1. PowerPoint Presentation by Charlie Cook Copyright © 2004 South-Western. All rights reserved. Chapter 9 Efficient Markets and International Interest Parity

2. Copyright © 2004 South-Western. All rights reserved.9–2 Fundamental Issues 1.What is the distinction between adaptive and rational expectations? 2.What is the efficient-markets hypothesis? 3.How are the prices of financial instruments determined in efficient markets? 4.What is the forward exchange market? 5.What is covered interest parity? 6.What is foreign exchange market efficiency?

3. Copyright © 2004 South-Western. All rights reserved.9–3 Expectations of Market Values of Financial Instruments Rational expectations hypothesis:  The idea that individuals form expectations based on all available past and current information and on a basic understanding of how markets function. Adaptive expectations:  Expectations that are based only on information from the past up to the present.

4. Copyright © 2004 South-Western. All rights reserved.9–4 Expectations of Market Values of Financial Instruments (cont’d) Representative-agent assumption:  The assumption that every trader in the marketplace can obtain the same information and has the same basic view of how the market operates.

5. Copyright © 2004 South-Western. All rights reserved.9–5 The Efficient-Markets Hypothesis Efficient-markets hypothesis:  A theory that stems from the application of the rational expectations hypothesis to financial markets.  It states that equilibrium prices of and returns on financial instruments should reflect all past and current information plus traders’ understanding of how market prices and returns are determined.

6. Copyright © 2004 South-Western. All rights reserved.9–6 The Expected Price of a Financial Instrument P e :  The expected average, or mean value, of the market price. P f :  The forecast value for the market price. P f = P e  When all traders form their individual forecasts rationally, their forecasts typically will correspond to the average market price.

7. Copyright © 2004 South-Western. All rights reserved.9–7 Actual And Forecast Prices Of Financial Instruments Actual price ( P ):  Reflects random factors that could not be anticipated in advance. Market price ( P e )and Forecast ( P f ) price :  The financial instrument’s average price ( P e ) plus an unpredictable random component (e):

8. Copyright © 2004 South-Western. All rights reserved.9–8 Can People Beat the Market? In an efficient financial market, there should be no unexploited opportunities for traders to earn higher returns. Insider information:  Information that is not available to the public.

9. Copyright © 2004 South-Western. All rights reserved.9–9 The Forward Exchange Market Forward exchange market:  The market for currency to be delivered at a future date via forward currency contracts. Forward discount:  A negative value for the difference between the forward exchange rate and the spot exchange rate divided by the spot exchange rate. Forward premium:  A positive value for the difference between the forward exchange rate and the spot exchange rate divided by the spot exchange rate.

10. Copyright © 2004 South-Western. All rights reserved.9–10 Relating The Forward Exchange Rate To The Spot Exchange Rate Standard forward premium or discount: F N = forward exchange rate S = spot exchange rate N = number of months of the forward contract

11. Copyright © 2004 South-Western. All rights reserved.9–11 Exchange Rates Table 9–1 MonetaryU.S.DollarCurrency per CountryUnitEquivalentU.S.Dollar European Monetary UnionEuro0.96951.0315 3-month forward0.96561.0356 6-month forward0.96161.0399 AustraliaDollar0.53541.8678 BrazilReal0.33502.9850 CanadaDollar0.63511.5746 China, P.R.Yuan0.12088.2766 DenmarkKrone0.13057.6615 Hong KongDollar0.12827.8000 IndiaRupee0.020548.6700 JapanYen0.0083120.4300 3-month forward0.0083119.9000 6-month forward0.0084119.4100 SOURCE: Federal Reserve Bank of New York, August 9, 2002.

12. Copyright © 2004 South-Western. All rights reserved.9–12 The Forward Exchange Market and Covered Interest Parity Covered interest parity:  A prediction that the interest rate on one nation’s financial instrument should:  approximately equal the interest rate on a similar instrument in another nation plus the forward premium,  or the difference between the forward exchange rate and the spot exchange rate divided by the spot exchange rate.

13. Copyright © 2004 South-Western. All rights reserved.9–13 Covered Interest Parity Example

14. Copyright © 2004 South-Western. All rights reserved.9–14 Uncovered Interest Arbitrage Uncovered interest parity:  No forward exchange contract or hedge is purchased to offset the foreign exchange risk.  Uncovered interest parity condition (assuming U.S. dollar/euro exchange values) is expressed as: r US = dollar-denominated interest return r E = euro-denominated interest return s e = expected rate of dollar depreciation RP = risk premium

15. Copyright © 2004 South-Western. All rights reserved.9–15 Foreign Exchange Market Efficiency Foreign exchange market efficiency:  A situation in which the equilibrium spot and forward exchange rates adjust to reflect all available information.  The forward premium is equal to the expected rate of currency depreciation plus any risk premium.  The forward exchange rate on average predicts the expected future spot exchange rate.

16. Copyright © 2004 South-Western. All rights reserved.9–16 Real Interest Parity  rearrange this expression for the real interest rate: Fisher equation:  An equation stating that the nominal interest rate equals the sum of the real interest rate and the expected inflation rate.  The real interest rate equals the nominal interest rate less the expected inflation rate:

17. Copyright © 2004 South-Western. All rights reserved.9–17 Combining Relative Purchasing Power Parity And Uncovered Interest Real interest parity:  An equality between two nations’ real interest rates that arises if both uncovered interest parity and relative purchasing power parity are satisfied.

18. Copyright © 2004 South-Western. All rights reserved.9–18 SOURCE: Robert Flood and Andrew Rose, “Uncovered Interest Parity in Crisis: The Interest Rate Defense of the 1990s,” Center for Economic Policy Research Discussion Paper No. 2943, September 2001. Estimates of Excess Returns on International Bond Trading Figure 9–1